February 11, 2022

So far, the recovery has generated a positive correlation between the inflation and real GDP growth. The stock market has appreciated as the Keynesian scenario suggests. Going Forward the question is what is in store for the economy as it returns to its long-term growth trend? Given the differences in valuation or stock market outcomes associated with rising prices it behooves the investors to identify the scenarios and position their portfolio to take advantage of a possible changing economic environment. So, the question is how can an investor tell which scenario is playing out? The rising prices create a signal extraction problem for the investors . There are two ways to obtain the correct signal. One way is to analyze the policies being enacted and then determine their impact on aggregate demand and aggregate supply. A second option is to focus on the correlation between the inflation and real GDP growth and reverse engineer the disturbance. For example, we have shown that demand shift generates a positive correlation between inflation and real GDP growth is the Keynesian scenario and a rising inflation rate is bullish for stocks. Under the Supply Side scenario, the rising inflation is bearish and under the Monetarist scenario the rising inflation has no impact on the real valuation. Stagflation is the child of aggregate supply shocks while the Phillips Curve the offspring of aggregate demand disturbances.

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