Macro Regimes: Growth, Inflation and What Works in Each Quadrant

Investors who learned their trade after the early 1980s learned it inside a single long disinflation, and the habits formed in that period were reasonable habits given the evidence available at the time. Bonds rallied when equities fell, because the thing frightening equity investors was almost always weakening growth, and weakening growth meant lower policy rates. A generation came to describe that offsetting behaviour as a property of the two asset classes, when it was a property of the economic weather, and the weather in the 1970s had produced the opposite relationship for anyone old enough to remember it.

The framework for thinking about this is simple enough to draw on the back of an envelope, which is both its appeal and the source of most of the nonsense written about it: growth is surprising to the upside or the downside, inflation is doing one or the other, and crossing the two gives four boxes with different asset behaviour in each. It has been used for decades. Its record as a forecasting tool is considerably worse than its record as a diagnostic one, and the distinction between those two uses is the most important thing on this page. Familiarity with how the Federal Reserve operates and with duration is assumed throughout.

Two variables, because they are the two halves of a valuation

Growth and inflation earn their place. Between them they set both parts of a discounted cash flow. Growth determines the numerator. That is the stream of cash businesses are expected to generate. Inflation, through the policy rate it provokes and the term premium it supports, sets much of the denominator, the rate at which that stream is discounted back, a channel the interest rates and stocks guide works through in detail.

What matters for asset prices is the change relative to what was already priced. An economy expanding at 2 percent when 3 percent had been expected behaves, in markets, exactly like a slowdown, notwithstanding that 2 percent is a perfectly respectable number, and every quadrant below should be read as a direction of surprise.

Quadrant	Growth	Inflation	Assets that have historically led
Disinflationary expansion	Rising	Falling	Equities broadly, credit, long duration growth stocks
Inflationary expansion	Rising	Rising	Commodities, energy and materials equities, TIPS, value
Disinflationary slowdown	Falling	Falling	Long Treasuries, cash, defensive equity sectors
Stagflation	Falling	Rising	Commodities, TIPS, cash at a rising policy rate

What each box has looked like

Disinflationary expansion is the quadrant in which most investors have spent their careers. Earnings grow, the discount rate holds or falls, multiples expand, and credit spreads grind tighter through a long sequence of quarters in which very little appears to happen, while long duration assets of every description do well, a category containing both Treasuries and the growth equities whose value sits furthest out in time.

Inflationary expansion rewards whatever is being bought. Commodity producers earn on volume and price at once, and companies able to raise prices faster than their input costs rise protect their margins while others do not, while nominal bonds lose ground as the policy rate climbs and inflation linked securities hold their real value by construction.

Disinflationary slowdown is the classic recession trade, in which the Federal Reserve cuts, the front end of the curve falls faster than the long end, and long Treasuries deliver their largest gains in precisely the months when equities deliver their worst. This is the quadrant that built the reputation of the 60/40 portfolio. The yield curve guide covers the shape changes involved in getting there.

Stagflation removes the cushion, because a central bank cannot cut into rising prices without abandoning the price stability half of its mandate, so the policy rate stays high while activity weakens underneath it; cash earns a real return for once, commodities can rise on supply constraints that have nothing to do with demand, and both halves of a conventional portfolio lose at the same time for the same reason.

Nowcasting, which is the honest version of the exercise

The quadrant cannot be forecast with any reliability. It can be estimated for the present, with a lag measured in weeks, and that estimate is what the framework actually supports.

For inflation, use the short run annualized rate. The year over year figure carries eleven months of history that has already been priced. Take three consecutive monthly core CPI prints of 0.2, 0.3 and 0.2 percent, compound them and annualize:

(1.002 x 1.003 x 1.002)^4 - 1 = 1.007016^4 - 1 = 0.0284

That is 2.84 percent annualized, close enough to the 2 percent objective to be consistent with continuing disinflation, and it would be entirely invisible in a year over year series still carrying much larger prints from the previous spring. The CPI guide explains why the shelter component makes even this calculation lag the underlying reality.

For growth, use the series that arrive first: weekly jobless claims, the monthly payrolls report covered in the jobs report guide, and the purchasing manager surveys, all of which lead the quarterly GDP releases by months; the yield curve adds the market’s own reading, and the recession indicators guide sets out the record of each signal along with the long and variable lags that follow an inversion. No single one of them settles the question. Anyone presenting one of them as though it does has stopped doing the work.

The 2022 arithmetic, which is the clearest teaching example

Through the 2010s the standard balanced portfolio worked partly because the two legs were negatively correlated, and every growth scare sent yields down and bond prices up while equities fell.

In 2022 the Federal Reserve raised the funds rate from near zero to above 4 percent inside a single calendar year in response to inflation well above target. Consider a bond portfolio with a modified duration of 6.5 years. Yields rise 2.5 percentage points. The first order price effect is

-6.5 x 2.5 = -16.25 percent

before any coupon income or convexity adjustment softens it. Equities were repriced by the same rise in the discount rate over the same months, and both legs fell together for one reason: the diversification that investors believed they owned had been a feature of the disinflationary regime all along.

Transitions are where the money moves and the labels fail

Within a stable quadrant returns are reasonably predictable and mostly already priced, so the large moves happen at the turn, and the turn is exactly what nobody identifies while it is happening.

Consider the sequence around a typical peak. Growth data still looks strong, inflation is still elevated, the committee is still tightening, and the yield curve has already inverted. Long Treasuries begin to rally. The cuts they are pricing will not arrive for a year. Credit spreads stay tight until they gap. The equity index makes a high. The number of stocks participating narrows.

Every one of those is unmistakable in retrospect. In the moment they are indistinguishable from a mid cycle slowdown that resolves upward, and the historical record contains several examples of each. What the market expects the committee to do is itself readable from fed funds futures, and a sustained change in that implied path is often the earliest hard evidence that a transition has begun, though it stops well short of confirmation.

Using the framework as an audit

The honest application is to examine a portfolio.

Take the allocation you hold. Ask what it earns in each of the four boxes. A portfolio of large cap US equities and long duration bonds does well in one quadrant, acceptably in a second and badly in the other two, which makes it a concentrated macro bet however diversified it appears when counted by the number of securities in it. Most investors who run the exercise discover they are positioned for rising growth and falling inflation without ever having decided to be.

The all weather response holds assets that lead in each quadrant, sized by risk contribution, on the reasoning that a quarter of the dollars in long Treasuries contributes far less risk than a quarter in equities. Scaling the lower volatility legs up usually requires leverage, which is a real cost and a real vulnerability, and the approach struggles when cash yields rise quickly because the financing gets more expensive at the least convenient moment.

A simpler version requires no leverage at all: hold some exposure to the inflation quadrants through commodities, inflation linked bonds or equities with genuine pricing power, accept that those holdings will lag for long stretches, and size them so that the lagging is survivable. The asset allocation guide covers the underlying construction.

The limits, stated plainly

The sample is small. The postwar United States offers perhaps a dozen distinguishable macro regimes and only one clear stagflation episode, so any statistical claim built on it is fragile, and the confident tables of average returns by quadrant that circulate in presentations rest on precisely that fragility.

Classification is ambiguous. Growth and inflation do not move in tidy steps, and a quarter of decelerating growth with sticky inflation can be labelled two different ways by two reasonable analysts working from the same releases.

And the framework says nothing whatever about valuation. An asset that has historically led in a quadrant can already be priced for that quadrant, in which case arriving there earns you nothing at all. Regime work describes the direction of the economic wind and says very little about what the wind already costs, which is where factor and valuation discipline has to do the remaining work, and where the yield curve tool is worth keeping open while you think it through.