Market Snapshot: Stagflation is ‘a legitimate risk’ that would be painful for U.S. markets

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The possibility of stagflation — an economic environment marked by high unemployment, high inflation, and low economic growth, experienced in the U.S. in the 1970s — has moved onto the radar screen of some market analysts.

“Stagflation is absolutely the biggest risk for every investor,” said Nancy Davis, founder of Quadratic Capital Management, in an interview. It imperils the “magical stock-bond correlation that everyone expects” will keep their investment portfolios diversified should risk appetite fall.

When stocks tumble in times of tumult, bond prices tend to rally as investors pile into them for safety, but a traditional portfolio of 60% stocks and 40% bonds could see a “disastrous outcome” should stagflation show up, Davis warned.

That’s partly because inflation erodes the value of bonds, typically prompting investors to sell and the result is price declines and higher yields.

“Imagine how scary it would be for the market if we had stocks and bonds selling off together,” she said. Stagflation could pose a “major problem because central banks can’t really come to the rescue and cut interest rates .”  

Investors will be closely watching the Federal Reserve’s policy meeting next week, looking for any shifts in the accommodative stance it took toward markets at the onset of the coronavirus pandemic last year. While U.S. inflation has recently surged, Fed Chair Jerome Powell has reiterated that the jump in the cost of living will be temporary as it’s tied to the labor and product shortages being experienced in the economic rebound from the Covid-19 crisis this year.

The Fed has been letting the economy run hot in the meantime, aiming for more progress in the labor market

“I see it as a legitimate risk,” Nathan Sheets, chief economist at PGIM Fixed Income, told MarketWatch, calling the possibility “a pain trade for markets.” Stagflation is not the base case for Sheets, who said he is more concerned about inflation becoming persistently high than about stagnating economic growth. Still, even after a rapid recovery from the Covid-crisis, the U.S. economy is down around 7 million jobs, Sheets said.

In his view, the recent decline in U.S. bond yields is signaling concern that economic growth may have peaked and may stagnate in the medium term, whereas the equity market appears to have “sunnier” expectations. “There does seem to be a disjuncture,” he said, describing the bond market’s outlook as “restrained at best,” while investor enthusiasm in the stock market has pushed major U.S. stock indexes to all-time highs.   

The Dow Jones Industrial Average
DJIA,
-0.14%
,
S&P 500
SPX,
+0.01%

and Nasdaq Composite
COMP,
+0.16%

indexes all closed at fresh peaks Friday, with the Dow closing above 35,000 for the first time, as investors brushed off concerns over the rapidly spreading delta variant of the coronavirus. 

The yield on the 10-year Treasury note
TMUBMUSD10Y,
1.283%

settled Friday at 1.286%, down about 1.4 basis points for the week, according to Dow Jones Market Data. That marked a fourth straight week of declines, and compares with a yield of about 1.75% at the end of March. 

“Possible explanations for the rate plunge are wide-ranging,” Oaktree Capital Management said this month in its second-quarter report. “They include investors’ belief that price increases will soon decelerate, strong foreign appetite for U.S. debt,” as well as fears that the delta variant could slow global economic growth, said Oaktree. Another explanation could be that “expectations that slightly tighter monetary policy in the next few years” could lower the probability of “runaway inflation” along with the resulting need for significant interest rate hikes, the report said.

Read: Bond yields and tech stocks echo ‘extreme anomalies’ of dot-com boom, says Morgan Stanley

Daniela Mardarovici, co-head of U.S. multisector fixed income at Macquarie Asset Management, told MarketWatch that stagflation is not her base case but it is “very much on the radar” as “it would be a painful scenario if it happened.” Mardarovici believes inflation shouldn’t “get out of control,” but, she said, “if we keep going into lockdown” then global supply-chain disruptions “might not be all that temporary.” 

Supply chain disruptions also worry Quadratic’s Davis. 

The Quadratic founder sees the risk of stagflation as being partly tied to the “global chip crisis.” A pandemic-related shortage of microchips, which “go into everything” from cars to appliances to phones and computers, is adding fuel to inflation, Davis said. Labor shortages in some industries can also contribute to higher prices, she added. 

The U.S. consumer price index, or CPI, climbed 5.4% in the 12 months through June, with prices rising at the fastest pace since 2008, MarketWatch reported earlier this month.

“People in their day-to-day life are experiencing higher prices,” not all of which is captured by CPI, Davis said. “The question is whether it’s going to be something that hurts growth or something the market just looks through.”

Oaktree said in its report that “investors don’t appear overly concerned” about rising inflation in the U.S. “But if inflation rates remain high or the global economic recovery wobbles, today’s complacent buyers could quickly turn into tomorrow’s panicky sellers,” the firm said.

Tiffany Wilding, North American economist at PIMCO told MarketWatch that she expects core CPI inflation to be at 4% by the end of this year, falling closer to 2% at the end of 2022. Her forecast is for the U.S. economy to grow 7% in 2021 and then “settle down” to about 3.5% by the end of next year.

“We think goods demand has peaked,” Wilding said. “And as that demand recedes in the back half of the year, you will see inflation coming down.”

While Wilding does not expect to see stagflation, she said that it’s something that could potentially emerge through supply-chain shocks in an environment where a rise in Covid cases “knocks out production” in the U.S. or among “our trading partners.” 

Investors don’t have to be convinced of stagflation to begin thinking about protecting their portfolios through diversification, which could include some exposure to treasury inflation-protected securities, or TIPS, according to Davis.

Investors may meanwhile be studying the trajectory of the yield curve for the bond market’s take on growth and inflation. 

“It may be too much to say the flattening of the bond yieldcurve is the market pricing stagflation,” said Chris Weston, head of research at Pepperstone, in a recent note, describing that scenario as the “worst backdrop” for equity and risk assets. “But it can’t be far off the mark,” he said. 

In his view, the flattening of the curve “clearly portrays inflationary pressures sticking around” longer than many policymakers had expected. “A normalisation of central bank policy into a period of slower growth is one risk assets do not enjoy – when in doubt, take risk off the table,” he wrote.

This week all eyes will be on the Fed as it will hold a two-day policy meeting that will conclude with Chair Powell speaking at a press conference on Wednesday July 28.

Investors will also be watching for the first reading of second quarter U.S. GDP on Thursday which is expected to accelerate to 8.4% annualized from 6.4% in the first quarter. Data on core inflation, and personal income and expenditure for June is also due Friday.

See: Fed to tiptoe towards tapering next week