Gas lines of the 1970s left an indelible impression of stagflation on the popular imagination of stagflation.
National Archives/Alamy Stock Photo
There is no question that Russia’s invasion of Ukraine is going to push inflation higher, given the amount of energy and food commodities produced by the region and the responses by countries and companies world-wide. What is less clear is whether this worsening period of inflation will turn into stagflation.
Since Russia began its invasion of its neighbor, the price of wheat has risen more than 20% and the price of crude oil by about 10%. The world’s biggest shipping companies, which together control about a third of the world’s container fleet, have meanwhile said they would suspend all deliveries to and from Russia, notes Eddie Donmez, director at Amplify Trading. Those moves will exacerbate strains in supply chains and lead to price increases for food, fuel, and more at a time when global central banks are just starting to move to combat pricing pressures.
With consumer price inflation in the U.S. already running at an annualized pace of 7.5%—the highest in about four decades and far above the Federal Reserve’s longstanding 2% target—investors should brace for even higher prices for even longer. The question then becomes whether central bankers will prioritize price stability and keep tightening monetary policy at the expense of growth.
Against this backdrop, it makes perfect sense that investors and economists are increasingly worried about the worst-of-both-worlds scenario of high prices and slowing growth. It’s the economic call du jour, which shouldn’t be all that surprising. But how likely is stagflation? And what’s an investor to do in the face of it? Here is a rundown of what it is, why the odds of stagflation are rising, and where investors can seek cover.
What is stagflation, really?
Economists broadly consider stagflation to represent periods of high prices and slow growth. As Peter Boockvar, chief investment officer at Bleakley Advisory Group, puts it: Stagflation is a central bank’s worst nightmare.
But what is high and what is slow? It depends on whom you ask. Jim Paulsen, chief investment strategist at the Luethold Group, says stagflation by its simple definition isn’t as uncommon as it might seem. It’s a term mainly associated with the 1970s, but Paulsen says most recoveries end with stagflation, often before turning into recession.
“Could we have stagflation? Absolutely,” says Paulsen. “In fact, we’re already in it.”
If stagflation is already upon us, how worried should you be?
While prices will no doubt stay higher for longer, Paulsen still expects the consumer-price index to slide to around 4% by year end as inflation-adjusted gross domestic product cools from 5.7% in 2021 to about 4%. Slowing growth and elevated inflation, but not quite a recipe for stagflation, he says.
The time to worry, Paulsen says, is when you see the most economically damaging aspects of high prices and slow growth. It’s when corporate profitability becomes compromised that things get hairy. Companies respond by cutting jobs, which then kicks off the kind of high unemployment that helped characterize the ’70s.
That sounds optimistic. Are others more worried?
The situation in Ukraine has unleashed derisking that implies bond markets are increasingly pricing in stagflation, says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. U.S. inflation breakeven curves—which indicate market expectations for future inflation—have blown out, she says. Two-year inflation expectations are near 4% as nominal yield curves, at their flattest since the pandemic’s onset, reflect downbeat economic growth expectations.
“We remain wary of Fed policy uncertainty and execution; rebalancing of consumption; and inflation’s impact on profit margins,” suggesting lower multiples, weaker earnings revisions, and wider term premiums and credit spreads, Shalett says. She adds that is sensing complacency around the sustainability of operating profit leverage as demand was likely pulled forward by the pandemic and as nearly three-quarters of earnings guidance has so far been negative.
At MSCI, Daniel Szabo and Thomas Verbraken lay out a grim scenario, where the conflict in Ukraine continues and the West responds with multiple rounds of long-lasting sanctions. As energy prices surge to significantly higher levels, fears of supply-chain bottlenecks push up longer-term inflation expectations, further weaken business and consumer confidence and slow economic growth.
“In this scenario, central banks are caught between two fires and cannot postpone monetary tightening for very long,” they say, meaning stocks plunge, credit spreads rise, and the U.S. dollar gains versus the euro.
Could the Fed instead choose to protect growth over fighting inflation?
As it prepares to begin withdrawing extraordinary pandemic aid and lift interest rates this month, the Fed hopes to orchestrate a so-called soft landing and avoid a recession. Shalett thinks the central bank will prioritize protecting growth over defeating inflation, but she says walking back from its current projected policy path is “ hugely risky, setting the bar for a subsequent policy pivot very high.”
Ed Yardeni, president of Yardeni Research, has said he could see the Fed raising its inflation target to 3% from 2% in an effort to claim victory on inflation sooner and with less harm to growth—even if that is at the expense of faster price inflation over the longer term.
Where are the best places to turn?
Given mounting uncertainty over how inflation, recession, and stagflation will play out, Shalett recommends sticking with quality, strong cash flows and “earnings achievability” that isn’t fully priced. Financials, materials, energy, consumer services and healthcare look rife with opportunities, while domestic small-caps and emerging markets may enjoy longer-term valuation support, she says.
Paulsen of Leuthold Group says the odds favor the conflict in Ukraine ending relatively soon, meaning inflation sputters from current levels in the coming months. He thinks Australian and European stocks will be the biggest beneficiaries of peace, and his favorite play on such a scenario is to buy emerging markets—excluding China.
“As a stock investor, I love the combination of accelerated and intense fear with good economic and corporate fundamentals,” Paulsen says, suggesting investors also consider equal-weighted exchange-traded funds that effectively deliver small-cap cyclical exposure. That’s as opposed to market-cap weighted ETFs that are dominated by the likes of Amazon.com (ticker: AMZN).
As for full-blown stagflation, strategists say the best moves are into commodities. Boockvar of Bleakley Capital emphasizes metals as miners, oil companies and fertilizer manufacturers. Then there’s cash, which Boockvar says is probably—and unfortunately—the safest place to be during the kind of stagflationary stretch he says is already under way.
Write to Lisa Beilfuss at [email protected]
