Stagflation is ‘a legitimate risk’ that would hurt US markets

The possibility of stagflation – an economic environment characterized by high unemployment, high inflation and low economic growth, such as that experienced in the US in the 1970s – has hit the radar screen of some market analysts.

“Stagflation is definitely the biggest risk for any investor,” Nancy Davis, founder of Quadratic Capital Management, said in an interview. It jeopardizes the “magic correlation between stocks and bonds everyone expects” to keep their investment portfolios diversified when risk appetite falls.

When stocks plummet in times of turmoil, bond prices tend to rise as investors pile into them for safety, but a traditional portfolio of 60% stocks and 40% bonds could see a “disastrous outcome” if stagflation sets in, it warned. davis.

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

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

Investors will closely monitor the Federal Reserve’s policy meeting next week, looking for any shifts in the accommodative stance it took on markets at the start of the coronavirus pandemic last year. While US inflation has risen recently, Fed Chair Jerome Powell has reiterated that the rise in the cost of living will be temporary as it relates to the labor and product shortages occurring during the economic recovery from the Covid-19 crisis. this year.

Meanwhile, the Fed is warming up the economy and is 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 opportunity “a painful trade for markets.” Stagflation is not the base case for Sheets, who said he is more concerned about continued high inflation than stalling economic growth. Still, even after a rapid recovery from the Covid crisis, the U.S. economy has fallen by about 7 million jobs, Sheets said.

He believes the recent decline in US bond yields is a sign of concern that medium-term economic growth has peaked and may stagnate, while the stock market appears to have ‘sunny’ expectations. “There appears to be a disjunction,” he said, describing the bond market outlook as “reluctant at best,” as stock market investor enthusiasm has driven major US stock indices to record highs.

The Dow Jones Industrial Average DJIA,
+0.68%,
S&P 500 SPX,
+1.01%
and Nasdaq Composite COMP,
+1.04%
all indices closed new highs on Friday, with the Dow closing above 35,000 for the first time as investors brushed aside concerns about the rapidly spreading delta variant of the coronavirus.

The return on the 10-year Treasury TMUBMUSD10Y,
1.276%
traded at 1.286% Friday, down about 1.4 basis points for the week, according to Dow Jones Market Data. That marked a fourth straight week of declines, compared to a return of about 1.75% at the end of March.

“Possible explanations for the share price decline are broad,” Oaktree Capital Management said this month in its… second quarter report. “They include investor belief that price increases will slow down soon, a strong foreign appetite for U.S. debt,” as well as fears that the delta variant could slow global economic growth, Oaktree said. Another explanation could be that “anticipation of monetary policy tightening slightly in the coming years” could reduce the likelihood of “runaway inflation” along with the consequent need for significant rate hikes, the report said.

Read: Bond yields and tech stocks reflect ‘extreme anomalies’ of dotcom boom, says Morgan Stanley

Daniela Mardarovici, co-head of US multisector fixed income at Macquarie Asset Management, told MarketWatch that stagflation is not its base case, but that it is “very much on the radar” because “it would be a painful scenario if it happened.” Mardarovici believes inflation should not “get out of hand”, but, she said, “if we continue to go into lockdown”, disruptions to the global supply chain “may not be so temporary”.

Supply chain disruptions also worry Quadratic’s Davis.

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

The US Consumer Price Index, or CPI, rose 5.4% in the 12 months to June, with prices rising at the fastest pace since 2008, MarketWatch reported earlier this month.

“People in their day-to-day lives face higher prices,” Davis says, not all of which is captured by CPI. “The question is whether it will be something that hurts growth or something that the market just sees through.”

Oaktree said in its report that “investors don’t seem overly concerned” about rising inflation in the US “But if inflation remains high or the global economic recovery falters, today’s complacent buyers could quickly turn into tomorrow’s panicked sellers.” the company said. .

Tiffany Wilding, a North American economist at PIMCO, told MarketWatch she expects core CPI inflation to reach 4% by the end of this year, and closer to 2% by the end of 2022. Her prediction is that the US economy will grow by 7% in 2021 and then “rest” to about 3.5% by the end of next year.

“We think demand for goods has peaked,” Wilding said. “And if that demand decreases in the second half of the year, you’ll see inflation fall.”

While Wilding doesn’t expect stagflation, she said it’s something that could potentially arise from supply chain shocks in an environment where a rise in Covid cases is shutting down manufacturing in the US or at “our trading partners.”

Investors don’t need to be convinced of stagflation to think about protecting their portfolios through diversification, which Davis says could include some exposure to Treasury-backed securities, or TIPS.

Investors, meanwhile, can study the yield curve trajectory for the bond market’s view of growth and inflation.

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

He said the curve flattening “clearly shows that inflationary pressures are lasting longer” than many policymakers had expected. “A normalization of central bank policy in a period of slower growth is a risk that assets do not enjoy – when in doubt, take risk off the table,” he wrote.

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

Investors will also be on the lookout for the first reading of US GDP in the second quarter on Thursday, which is expected to accelerate to 8.4% yoy from 6.4% in the first quarter. Core inflation and personal income and expenses data for June are also expected next Friday.

To see: Fed on the toes towards tapering next week

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