Slower growth and rising inflation has brought back distant cries that stagflation is coming.
This would force interest rates to stay higher for longer, putting pressure on US businesses and consumers.
One investor says anyone looking to hedge this risk should focus on fixed income.
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A pair of economic reports has brought back a word no central banker ever wants to hear: stagflation.The difficult scenario occurs when inflation rises and growth stalls, a dangerous combination just experienced by the US economy.Worries emerged when Thursday’s first-quarter GDP reading slumped against expectations, growing at an annualized 1.6% rate. That’s a considerable slowdown from previous quarters, and falls well under estimates of 2.5%.Just a day later, personal consumption expenditures did the opposite, outpacing forecasts on Friday. The inflation metric, favored by the Federal Reserve, rose 2.8% against a 2.7% consensus.”If you take [the] inflation report in conjunction with yesterday’s GDP report, I think what investors really have to start positioning themselves for is the resurgence of the stagflation debate,” LPL Financial’s chief economist Jeffrey Roach told Business Insider.If this was to actually take hold, it would not be a welcome sight for markets. Lessons can be drawn from the 1970’s, a decade often cited as cautionary tale. Iin that era, a cycle of low growth and double-digit inflation only ended after the Fed sent interest rates sky-high, driving the US into a recession. When issues first emerged, volatility sent stock markets falling.
To be sure, stagflation isn’t Roach’s base case, as he and other analysts will want to see more data points before making such a call. “It really all depends on the inflation part of the equation, and if that forces the Fed’s hand to be higher for longer,” said Mike Reynolds, vice president of investment strategy at Glenmede, told BI. He also noted that he’s recently become more attentive to stagflation risks.”A couple of Fed officials are floating ideas of maybe additional rate hikes — that’s not the consensus — but the fact that it’s being talked about now is kind of indicative of the situation that we’re in,” Reynolds said.Among the most prominent Wall Street voices warning of stagflation right now is JPMorgan CEO Jamie Dimon, who has made frequent references to the 1970s as a reason for why markets shouldn’t get too comfortable with the current economy: “I point out to a lot of people, things looked pretty rosy in 1972 — they were not rosy in 1973,” he recently told the Wall Street Journal, warning that a slowdown could come in the next two years, amid rising inflation.In the case that monetary policy is forced to stay higher this year, both Roach and Reynolds agreed that consequences could come about as soon as 2025. In Reynold’s view, any fallout would be delayed by election-related fiscal boosts, though this would only add to inflation, worsening the Fed’s options. Meanwhile, 2025 and 2026 will see both the government and businesses rolling over debt, Roach said, adding that if rates stay high, that only increases the risk of something breaking.To hedge against any rising risks, Reynolds suggested modestly going underweight on equities. He said this could be offset with additional exposure to fixed income, though investors shouldn’t overexpose themselves to duration, as future inflation risk could add upside to rates, weighing on long-dated assets.Alternative investments could counter any disappointment in bonds or equities, Roach said.But for now, stagflation is just a distant possibility, and the threat may diminish with future reports or a GDP revision, both experts noted. On Friday, Bank of America pushed against the scenario, citing no signs of stagflation. Echoing points by Reynolds, its note focused on the fact that first-quarter GDP fell on inventories, while consumer spending remained resilient — potentially boosting PCE.”This created a narrative of ‘stagflation’ or a negative supply shock. We think that view is misguided, as it is based on an apples-to-oranges comparison,” the firm said.
