Quantitative Analyst Toby Carrodus Explains Why Inflation Excites Him

While many investors and traders might have been fretting their way through an economic climate dominated by fears of rising ever-rising inflation, one clever quant has been making the most of it. So much so that he is relishing the challenge and how his investment style has fared. Here’s why inflation excites Toby Carrodus.

Inflation in the United States may have eased to 3% in June — the slowest it has been for more than two years — but at time of writing, pundits anticipated Fed officials would still raise interest rates when they met in July. Meantime, in the UK, the so-called inflation crisis is expected to last almost another year, analysts predict. From a trading and investing perspective, that’s all fine and dandy, says Toby Carrodus, an Australian stay-at-home dad, investor, and quantitative analyst.

“It’s not so much the concept of inflation per se,” he says in an interview. “It’s more the Central Bank’s reaction function to inflation.”

Toby Carrodus explains that over the past 15 years, investors, shoppers and even central banks have become complacent about inflation, because anytime there’s been “a bit of a wobble” in markets, central banks just print more money, and economies just carry on.

“They’ve been able to do that because we’ve been in quite a deflationary environment,” he says.

But now we have sudden inflation, and central banks have to raise rates.

Toby Carrodus on what happens in an inflationary environment

For Carrodus, inflation – and its impact on economies and the markets – is actually pretty straightforward.

“Typically when inflation occurs, the Fed or a central bank will raise rates basically until they break the economy, which puts the economy into recession. They’re trying to put us into recession to slow price growth (ie inflation). And when you enter recession, that’s typically when you get a lot of consolidation across industries. You have bigger cashed-up players buying out smaller companies who might not have such a strong balance sheet,” Carrodus explains, adding that in the last decade he thinks there have been a lot of companies that have only been profitable because interest rates have been so low. “So there’s going to be some consolidation. It typically causes a shake-up. And that’s where I think genuine growth and capturing market share happens. And you want to do your best to be prepared to be on the right side of that trade.”

In such an environment, there’s also typically a re-pricing in a lot of asset markets, and Toby Carrodus thinks real estate, for example, could take a hit.

“If you’ve got some cash aside, it might be a good opportunity to buy for the next cycle,” says Carrodus.

As a professional investor and quantitative analyst, it is these opportunities – if you can identify them – that excites Toby Carrodus about inflation.

“It can cause a crash. And if you’ve got some dry powder, that’s a great time to set yourself up for the next decade,” he says.

Why Toby Carrodus is poised to ride the inflationary wave

Toby Carrodus says he designs his trading portfolio so that it benefits from bear markets and still makes money in bull markets.

“It’s by taking a balanced, data-oriented, systematic approach using concepts that are pretty tried and tested and available out there for anyone. It’s just that you’ve got to be willing to put in the work,” he says, adding that the ability to trade currencies, commodities, stocks and bonds — and trade them all long or short — adds a breadth to his portfolio that investors will otherwise miss if they are simply investing long on equities or bonds.

For example, most people have a traditional 60/40 portfolio, he explains: 60% stocks and 40% bonds. For the last almost 30 years equities and bonds have been negatively correlated, which has been beneficial. But now with inflation surprises, says Toby Carrodus, equities and bonds have become positively correlated, because all the stimulus from governments and central banks is being withdrawn.

“If you just designed your system on the last 30 years of data where bonds and stocks have been negatively correlated, you could be getting caught out badly,” says Toby Carrodus. “So you’ve got to combine your data-oriented approach with some common sense. At a high level, that’s definitely what’s helped me make money this year.”

And Toby Carrodus’ account is up nearly over 50% at the time of our interview in late 2022.

Toby Carrodus ponders why central banks haven’t learnt the same lesson everyone else has

Toby Carrodus thinks it’s quite a peculiar feature of Western market economies that they have embraced market mechanisms to allocate resources in so many aspects of life but not in establishing short-term interest rates. We essentially have a centralized committee of bureaucrats operating a government monopoly on the money supply (which determines short-term interest rates). This contrasts starkly with the many other areas of life where we have adopted market mechanisms, often in areas previously considered inconceivable. He sees this as a useful lesson in the evolution of thinking.

“The airline industry was once a state-owned enterprise in most countries. And people thought back in the day, it was unfathomable that we would have a private provision of airline services, because it would cause erosion of standards. It was thought that competition and safety standards would drop and it would be a race to the bottom,” explains Toby Carrodus. “But here we are in the current era, and it’s almost unimaginable to think that airlines were once a government monopoly.”

The reason is that societies have generally learned through the 20th century that markets are a more efficient allocating mechanism than committees trying to collect and process information and agree on an appropriate response. Information in a market economy is decentralized and the person on the spot can adapt faster to changes in circumstances than any centralized body could.

Without a market mechanism, decision-makers have to collect all the information and send it to a central body which then takes time to react.

“And then their decision takes time to implement. And by the time they do that, the situation has typically changed. And that’s exactly what happens with monetary policy,” says Toby Carrodus.

It all reminds Toby Carrodus of the old tale of the fool in the shower.

Sometimes when shower faucets have a bit of a lag when controlling temperature, you can turn the faucet one way and get a scolding from the boiling hot water. So, you readjust. But then you get a shock from a blast of freezing cold water. It’s never quite right because of the lag of the information.

“And that’s the same process with central banks collecting information, making a decision, and then implementing that decision,” says Toby Carrodus. “By the time they’ve done that, because it happens with such a lag, the economy’s in a totally different spot and the chosen rate is actually not likely to be appropriate anymore.”

Furthermore, the economy is not a closed, controlled environment in which you can conduct experiments and test hypotheses like you could with a cube of copper. It is counterfactual, so the centralized committees of bureaucrats trying to create the optimal interest rate are essentially using ‘gut-feel’ to determine a massively important variable that impacts the life of every individual operating in that economy. Toby Carrodus poses the question, “Why not let the ‘person on the spot’ with localized knowledge decide via a market mechanism to determine the short-term interest rate as we do with the rest of the economy?”

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