The Stagflation Shift | Aahan Menon on What Works When Stocks and Bonds Don’t

Key Concepts

• Stagflation: An economic condition characterized by slow growth, high unemployment, and rising prices (inflation).
• Inflation Shock: A sudden, significant increase in the price of goods, particularly energy, which ripples through the economy.
• Demand Destruction: A long-term economic phenomenon where high prices force consumers to reduce consumption, eventually leading to a slowdown or contraction.
• Backwardation: A market condition where the spot price of a commodity is higher than the price of futures contracts, often signaling supply shortages.
• Risk Parity: An investment strategy that focuses on allocating capital based on the risk (volatility) of assets rather than dollar amounts.
• Macro Impulse: A proprietary metric used to explain changes in earnings expectations by combining price-based and fundamental data.
• Trend Following: A systematic investment strategy that buys assets when they are trending upward and sells or avoids them when they trend downward.

1. Macroeconomic Backdrop and the Inflation Shock

The current economic environment is defined by a "mixed" data set: a slowing labor market (driven by reduced immigration) contrasted with high output fueled by AI-related capital expenditure (capex). The speaker argues that the recent conflict in the Middle East acts as a major inflation shock, which clarifies the outlook by acting as a catalyst for potential recessionary pressures.

• Key Data: Month-on-month annualized CPI readings are currently in the "nines," representing one of the most material inflation shocks in recent history.
• The Mechanism: Energy price spikes bleed into the broader economy, eventually forcing consumers to reduce spending, which leads to demand destruction.

2. Asset Class Outlook and Expected Returns

The speaker notes that traditional 60/40 portfolios (equities and bonds) are poorly designed for sustained inflationary environments. Their research suggests the following hierarchy of expected returns:

1. Commodities (Energy): Highest expected returns, particularly during supply shocks.
2. FX (Foreign Exchange): Attractive due to interest rate differentials.
3. Fixed Income: Opportunities exist, but volatility is currently too high to justify large allocations.
4. Equities: Currently the least attractive asset class due to rich valuations relative to the macro outlook.

3. Systematic Frameworks and Methodologies

The Treasury Rule

To manage bond exposure, the speaker proposes a simple rule: Only hold Treasuries when the daily CPI now-cast is below 2%. This avoids the "falling knife" of rising yields during inflationary spikes while positioning for the eventual deflationary impact of demand destruction.

Trend Following Program

The speaker’s firm has made their trend-following methodology free to the public.

• Universe: Stocks, bonds, gold, and Bitcoin.
• Weighting: Risk-parity weighted.
• Signal Generation: A two-speed filter (1-month and 6-month trends).
  • Both signals positive = 100% position.
  • One signal positive = 50% position.
  • Both signals negative = 0% position.
• Risk Scaling: The portfolio’s target volatility scales based on the number of positive signals (from 0% to 15% risk).

4. Earnings Expectations and Vulnerability

The speaker argues that consensus earnings expectations are currently too high relative to what the macroeconomy can deliver. They utilize a "macro impulse" model to track deviations between consensus estimates and "macro fair value." They warn that the market is in a "window of vulnerability" where earnings expectations have not yet fully priced in the negative impacts of the energy shock.

5. Notable Quotes

• "The inflation shock actually serves to clarify the picture a lot... it is basically kind of like the recessionary catalyst that tariffs were supposed to be."
• "When it comes to commodities, you actually have the opposite kind of dynamic [to stocks/bonds] where it's the supply shocks that really make the commodities valuable at all."
• "If anybody claims that they are able to forecast their way through this [geopolitical volatility], I would be highly skeptical."

6. Synthesis and Conclusion

The primary takeaway for investors is the urgent need to move beyond traditional stock/bond allocations. In a regime of sustained inflation, commodities act as a necessary diversifier. Investors are encouraged to:

1. Diversify: Incorporate non-correlated assets like commodities.
2. Manage Risk: Ensure portfolio volatility is aligned with actual risk tolerance, rather than relying on notional 60/40 splits.
3. Adopt Systematic Rules: Use transparent, rules-based frameworks (like the Treasury 2% rule or trend following) to remove emotional decision-making during periods of high uncertainty.

The speaker emphasizes that while the current environment is difficult, the most durable approach is to define a base case, understand the "max loss" of that strategy, and maintain discipline through the volatility.