03 January 2023 Bitcoin & Crypto | Monetary Policy & Inflation | Rates | US

What Academia Taught Us in 2022, Part I

Summary

We’ve covered 46 academic papers in 2022, all published by leading institutions or journals. Here, we revisit some of the main punchlines.

Will Wages Push Inflation Even Higher?

Our most read Deep Dive of the year summarised work by prominent economist, Larry Summers. In it, he explained why quit and vacancy rates are the best indicators of labour market tightness. And, by deriving an unemployment rate from them, he projected 6%+ wage growth through 2023 – so far, he’s been spot on (Chart 1).

Predicting Mutual Fund Performance Using Machine Learning

Different to many of the pieces we’ve done this year, this NBER working paper shows how mutual fund performance can be predicted in real time. It’s our third most popular piece in 2022 and explains the type of machine learning model the authors use, which variables to include and where to get the data from – a very implementable strategy.

Fed Terminal Rate: Powell vs Volcker

Many are drawing comparisons between now and the 1970-80s. This piece warns against making careless parallels between inflation then and inflation today. If you have, then the conclusions you’ve drawn are probably overly optimistic! According to the paper, adjusting for differences in the way inflation is now measured makes the scale of disinflation required today more dramatic.

Updating the paper’s analysis, the Fed now needs to reduce headline and core inflation by 7pp and 4.7pp, respectively, from their peaks to reach its 2% target (Chart 3). This is only slightly less – just 0.2pp for core – than during the 1980s, when Paul Volcker increased the Fed Funds rate to 20%!

Investment Tips and Trading Insights From Wealthy Investors

The joint highest ranked journal article we’ve summarised a paper from this year, this Deep Dive is one of the most unique of 2022. The authors, in conjunction with UBS, conducted one of the largest surveys of wealthy (+$1mn) investors ever. It gave great insights into how they invest their money, and the results were not necessarily what I was expecting.

How Crypto Impacts Global Equity Prices

Back when Bitcoin was above $40,000, this piece garnered a lot of interest. A novel, but simple analysis done by an up-and-coming star economist, this Deep Dive showed how dramatically crypto markets influence equity markets. According to Tara, Bitcoin is now responsible for 17% of the daily volatility in US equity prices! Her results were published using 2020-2021 data, but correlations in daily returns have only risen in 2022 (Chart 3).

Breaking Conventional Wisdom on Permanently Lower Interest Rates

A brand new theory that aims to explain the long-term decline in the natural rate of interest. It lies in the communicational errors between the central bank and private sector. It’s actually very simple and intuitive – it did a good job of convincing me. It also means interest rates are likely to return to their zero lower bound if the central bank doesn’t change its ways.

A Framework for Forecasting US Inflation

In my opinion, the best framework in which to analyse the US’s past and future inflation dynamics. It’s very simple and flexible, allowing anyone to appraise the impact of a shock on prices. If there’s one thing academia is helpful for, it’s providing structure to otherwise unbounded problems.

Using the latest CPI data, it looks like we are heading for one of their more pessimistic projections – see Chart 7 in the Deep Dive. Headline CPI peaked at 9% this year (Chart 4), far higher than the sub 8% forecasted in the paper’s optimistic scenarios.

Picking Up Pennies in Bond Markets on FOMC Days

The other Journal of Financial Economic paper we covered in 2022 was able to exploit publicly available information pre-FOMC meetings to make money in bond markets. A strategy that goes short rates during the 30-minute window on months when GDP forecasts are revised upwards and long rates after downward revisions yields a mean annualised return of 15bps – not bad for four hours’ trading a year!

House Prices Push US Inflation Higher

Residential real estate has also been a hot topic of discussion in 2022. This Deep Dive explained how house prices feed into headline and core CPI, and showed that a 16m lag on the Zillow HVI is a good predictor of housing inflation! I just updated it, and it shows housing inflation is still unlikely to peak until August 2023 (Chart 5). Given it makes up roughly 30% of headline inflation, it will continue to put upward pressure on prices throughout 2023.

Stock Market Winners and Losers During the Russia-Ukraine War

Has ESG been on the back-burner in 2022 given everything else that’s playing out? This paper showed how firms with a high exposure to climate risk have been outperforming since the beginning of the Russia-Ukraine war, especially in the US. In other words, the market has priced a considerably protracted slowdown in the transition to a low-carbon economy – another negative impact from the conflict!

Is US Unemployment About to Rise?

This Deep Dive, co-authored by Oliver Blanchard, looked at vacancy rates and the unemployment rate to determine whether the Fed could achieve a ‘soft landing’. The conclusion wasn’t an optimistic one. History tells us that, in situations such as the current one, a decline in vacancy rates will always lead to a rise in the unemployment rate. In fact, according to the paper’s findings, the unemployment rate could go as high as 7.2% by 2024. So far, the latest data is within their forecasted range (Chart 6).

The Benefits of Volatility-Scaled Momentum Models

We’ve covered a few papers on momentum models this year – they tend to perform well during inflationary periods. This paper was only recently released in a top journal. It explains the benefits of accounting for volatility in stock markets alongside return momentum. This helps avoid the crashes that standard momentum models are prone to – a helpful tip for any investor.

US Recession: A Matter of When, Not If

Another Larry Summers piece, this time looking at the probability of the US entering a recession. Looking back through history, every time wage inflation exceeded 5% and the unemployment rate was at or lower than 4%, the US entered a recession.

Wages are now growing at much more than 5% YoY, and the unemployment rate is below 4%, making the implied probability of the US entering a recession before April 2024 100%. Growth did dip below zero in two consecutive quarters this year (Chart 7) but, if history is correct, we can expect a more protracted decline over the next 18 months.

Fiscal Consolidations to Cripple Growth in 2023?

Another recently released Deep Dive – this paper has been very popular. Its value is not in its complexity, but rather the simplicity. It succinctly covers multiple scenarios in which fiscal consolidations occur, stating their impact on key macroeconomic variables. It makes for rather bleak reading if you live in the UK: fiscal consolidations in highly indebted countries with weak growth and a hiking central bank have strong recessionary impacts, and are not guaranteed to actually reduce the debt-to-GDP ratio!

Bottom Line

Hopefully, you’ve found these papers as insightful and instructive as I have during a turbulent year. I get a sense academia has made a concerted effort to provide timely research on important topics in 2022, more so than in previous years, so let’s hope that trend continues into the next! Click here to read Part II, in which I’ll cover the most impactful charts from the academic pieces we’ve summarised this year – no reading required!

Happy holidays and best wishes from me for 2023!

Links to all Deep Dives in 2022

How to Build Eco-Friendly Portfolios (Without Losing Returns)

What Drives Stock Prices?

How Crypto Impacts Global Equity Prices

Trading During FOMC Meetings

Diversification Strategies for Global Equities and Crypto Investment

Forecasting the Fed’s Policy Rate

Predicting Mutual Fund Performance Using Machine Learning

Will Wages Push Inflation Even Higher?

How the Princeton School Shaped US Policy in the 21st Century

House Prices Push US Inflation Higher