Fears spread from Wall Street to Main Street that the US economy could slide into 1970s-style “stagflation”.
References to the difficult situation appeared in the headlines all week. The Associated Press called it “the dreaded ‘S’ word.” The Wall Street Journal reminded readers of the origins of neologism as a catchy way to describe an environment of slowing or stagnant economic growth, job losses, and inflation.
The World Bank also evoked them when on Tuesday it warned of a “protracted period of weak growth and elevated inflation” while announcing that it had just cut its outlook for global economic growth by almost a full percentage point.
On Friday things really got going. The May reading of the US CPI – a closely followed indicator of price pressures in the economy – dampened hopes on Wall Street and in Washington, DC that inflation had already “peaked”. Instead, headline inflation for May came in at an annualized 8.6%, a new cycle high.
Read: Rising rents, gas and food prices push US inflation to a 40-year high of 8.6%, CPI shows
Many economists were quick to note that the US hadn’t quite slipped into stagflation. Not with the still extremely robust labor market. The US economy also contracted in the first quarter, but few expect the same to happen in the second quarter.
Given the warning signs, it’s important to understand how stagflation could affect portfolios and savings.
The bottom line is: from SPX shares,
to gold GC00,
If stagflation becomes a reality, according to a handful of economists, portfolio managers and market experts, investors will have depressingly few options to protect themselves against the backlash.
Why should stagflation be a problem?
Concerns about stagflation often focus on the inflation side of the equation. As confirmed by Friday’s CPI figure, the pace of inflation accelerated to a new cycle high in May.
The data prompted a flurry of reactions from economists, including teams from Capitol Economics, Barclays and Jeffries, who suggested the Federal Reserve could opt to raise interest rates by 75 basis points when its policy body meets next week, perhaps at next meeting in July.
Others scoffed at the notion of “peak inflation,” the idea that price pressures peaked in March and then eased in response to Fed action. The Fed’s first rate hike since 2018 came in March, followed by plans for much higher interest rates this year.
The CPI data wasn’t the only alarming data points released on Friday. The University of Michigan consumer survey also showed that consumers are even more pessimistic now than they were in the depths of the financial crisis.
In terms of the pace of economic growth, there are signs that the US economy could be headed for negative growth in the first half of the year. The Atlanta Fed’s GDPNow forecast calls for economic growth of 0.9% in the second quarter after a 1.5% contraction in the first quarter.
Most economists define a recession as two consecutive quarters of economic contraction. Technically, even if the Atlanta Fed forecast came true, the US would not be in a recession even if the economy contracted in the first part of the year.
What the job market says
Employment remains the economy’s only bright spot for now, with the unemployment rate remaining at 3.6% in May as the US economy added 390,000 jobs.
However, the rising cost of consumer goods is taking its toll. Revolving consumer credit in the US – essentially a proxy for credit card use – exploded to near record levels earlier this month.
“Is this a sign of consumer health – or rather a consumer crying out in end-of-cycle pain as their incomes are crushed by the cost-of-living crisis?” Albert Edwards of Société Générale asked in a recent note to clients.
Tom Porcelli, a US economist at RBC Capital Markets, agreed that this could be a concern. “There’s been a pretty rapid acceleration in credit usage, I don’t think that’s a good development,” he said during a phone call with MarketWatch.
Related: Why the ‘explosive growth’ in US consumer debt could hit back, according to a researcher
Still, it will take more than just rising inflation and slowing economic growth: the US jobs market would also need to take a hit, pushing unemployment closer to 5% again.
If the Federal Reserve continues to raise interest rates and exogenous factors such as the war in Ukraine and increased commodity prices CL00,
As commodity prices continue to soar and hurt corporate profits, it’s possible that American companies could be forced to cut back. Only then would economists generally agree that “stagflation” has occurred.
How might markets react?
The hardest part about positioning a portfolio for this type of environment is that stocks and bonds are unlikely to do well.
In a stagflationary environment, you basically have a recession, which negatively impacts consumer demand and corporate earnings, and high unemployment, which could impact retail inflows into stocks.
On the fixed income side of the equation, stubbornly high inflation could force the Federal Reserve to keep interest rates high as it tries to contain price pressures. Rising inflationary expectations often force the term premium to increase — that is, the amount investors ask to compensate them for the risk of holding longer-dated bonds.
Mark Zandi, an economist at Moody’s Analytics, pointed out in a recent research note that the term premium for long-dated government bonds was over 5% during stagflation in the 1970s and early 1980s. Right now the Treasury yield is TMUBMUSD10Y,
The curve is essentially flat, meaning that if such an environment were to materialize, longer-dated government bond prices would have to come down significantly and yields rise.
“You really have nowhere to hide,” said Mohannad Aama, portfolio manager at Beam Capital Management.
In the past, Gold GLD,
is the preferred safe haven for investors in times of market turbulence. Gold posted its best day in about a week on Friday, although it initially fell to its weakest level in three weeks after Friday’s CPI report.
Although futures for the yellow metal were still more than 8% below the yearly high of $2,040.10 in March at nearly $1,875.50 an ounce according to Dow Jones Market Data, leaving many investors disappointed with its performance since early 2022. The shiny metal has held up better than stocks.
Inflation-Linked Government Bonds TIP,
are an option for investors looking to protect their money from the ravages of inflation. TIPS, as they are known, saw their returns at their highest levels since March 2020, according to Tradeweb data.
Heading into a stagflationary environment, it would also be reasonable to expect the US dollar to continue to appreciate as interest rates rise.
But once stagflation sets in, the Fed will likely be forced to make a choice: will the central bank keep raising rates to fight inflation, or will Fed officials cut rates to try to revive the economy?
In this scenario, Steven Englander, Global Head of G-10 FX Research at Standard Chartered, expects they will choose the latter.
“I think the Fed will compromise in this world,” he told MarketWatch.
US stocks ended the week sharply lower on Friday, falling after inflation data was released. The S&P 500 Index SPX,
shed 5.1% this week, posting its biggest two-week percentage decline since March 27, 2020, according to Dow Jones Market Data. The Dow DJIA,
fell 4.6% on the week, while the Nasdaq Composite Index COMP,
has lost 5.6% since Monday.
Looking ahead, it’s a busy week for US economic data. But all eyes will be on the Fed’s two-day monetary policy meeting, which ends on Wednesday, followed by a press conference at 2:00 p.m. EST with Fed Chair Jerome Powell.