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Uncommon Sense

Could ‘70s Era Stagflation Make a Comeback?

“I came of age and studied economics in the 1970s and I remember what that terrible period was like. No one wants to see that happen again.”

— Secretary of the Treasury Janet Yellen

Chief Investment Strategist

The economic soft landing has overwhelmingly become investors’ consensus outlook. And, why not? Economic data releases confirm that the soft landing is the most probable outcome. As a result, US large-cap stocks, primarily driven by just a handful of companies, continue to reach new heights. At 21.1, the S&P 500’s forward 12-month price-to-earnings (P/E) ratio is above both its 5-year (19.0) and 10-year (17.7) averages.1  Valuations remain elevated and investor sentiment is downright bullish.

But prudent investors should always push themselves to consider the risks to the investing environment. This is especially true when the conditions seem most bullish. Conversely, investors must also force themselves to employ courage, capital, and conviction when the investing landscape appears to be most bearish. Both behaviors are equally difficult to put into practice. That helps explain why there are so few successful long-term investors.

With the US economy humming along and the S&P 500 smashing through record highs almost daily, let’s be shrewd investors and force ourselves to explore at least one potential future alternative to the soft landing outcome — stagflation.

Stagflation is an environment in which slow economic growth, rising prices, and increasing unemployment all happen simultaneously. Stagflation was rampant in seven major economies from 1973 to 1982. Clearly there are a number of stark differences between then and now. The causes and effects may rhyme, but they are never exactly the same.

Admittedly, stagflation is a low probability outcome today. But after the harmful monetary, fiscal, and trade policies of the past two decades, a bout of stagflation isn’t totally farfetched. The United Kingdom and Japan are already in technical recessions and Germany will likely join them in the first quarter. In all three countries, current inflation rates are decelerating alongside economic growth but remain above long-term averages. Germany, Japan, and the UK are the third-, fourth-, and sixth-largest economies in the world.

The United States has been the shining star of the global economy — seemingly doing everything right. But is the US immune to the stagflation threat? The ingredients for stagflation are all present. Stubbornly restrictive Federal Reserve (Fed) monetary policy. A slowing US economy. Massive domestic and military spending resulting in ballooning government deficits. Sticky inflation. And rising bipartisan protectionism.

Investors may be underestimating the risk of a return to 1970s stagflation.

A Puzzling Economic Picture

The US economy isn’t on the brink of recession. Far from it. The latest Federal Reserve Bank of Atlanta GDPNow forecast estimates still-healthy annual GDP growth of 2.9% in the first quarter of 2024.2  But US GDP grew at an annual rate of 4.9% in the third quarter and 3.3% in the fourth quarter of 2023.3  It’s the decelerating trend in annual GDP growth that may be most alarming. The surprisingly strong pace of US economic growth is expected to cool considerably before year’s end.

In fact, as of February 21, Bloomberg forecasts annual US GDP growth of just 1.4% for all of 2024.

The Fed’s reluctance to cut interest rates until it gains greater confidence that inflation is moving sustainably toward 2% likely means that monetary policy will remain restrictive for at least several more months, possibly even a couple of quarters. This too will likely slow the economy.

Recent data releases paint a puzzling picture, teetering somewhere between solid economic growth and contraction. For example, on February 16, the University of Michigan Consumer Sentiment Index reached 79.6, its highest level since July 2021. Meanwhile, on February 20, the Conference Board’s Leading Economic Index declined for the 22nd consecutive month.

Yet, the labor market continues to flex its muscles, exhibiting durable strength. Until the jobs market falters, it’s difficult to envision a recession. And it would take rising unemployment, combined with the Fed’s stranglehold on the economy, for stagflation to take hold in the future.

Higher Prices Keep Their Hold

The threat of resurgent inflation might be the biggest reason investors should fear a potential stagflation outcome.

Both the Consumer Price Index (CPI) and Producer Price Index (PPI) came in hotter than expected on February 13 and 15, respectively. The data temporarily sent stocks reeling and Treasury yields surging. Market participants were forced to reduce the number of expected Fed rate cuts this year, as well as push the timing of the first cut further out in 2024.

Sell-side research firm Strategas Research Partners created its own “Common Man CPI” that includes the items people must buy, like food, energy, shelter, clothing, insurance, and utilities versus the things that they might like to buy — televisions, gym memberships, etc. In the most recent reading, the Common Man CPI rose 3.3% year-over-year, greater than the headline CPI figure of 3.1%.

Perhaps more importantly, Strategas’ Common Man CPI has grown faster than wages over the past five years. Using Strategas’ inflation measure, people may already be suffering from some form of stagflation. That might help explain why the Biden administration is polling so poorly on the economy despite record low unemployment and all-time high asset prices.

In addition, structural supply-demand imbalances in the labor and housing markets could also result in a revival of inflationary pressures. There’s a shortage of qualified skilled workers to fill open positions, which is keeping wages elevated. At the same time, the demand for affordable housing remains high while its supply remains low, inflating housing prices. The multi-decade transition from fossil fuels to cleaner energy is also proving to be surprisingly inflationary.

Similar to the 1970s, decades of massive domestic and military spending following periods of ultra-low interest rates have produced historic deficits. Big fiscal spending has likely contributed to increased inflation. Deglobalization, rising trade protectionism, and surging geopolitical conflicts — all of which could reduce global economic growth and lead to unexpected price shocks in commodities and possible supply chain disruptions — could further fuel inflation.

Getting back to Strategas Research Partners for a moment, they examined 24 countries and 62 historical inflation episodes and concluded that it’s rare for inflation to have only one wave of price surges. In fact, inflation returning in multiple waves is the more common pattern. According to Strategas, a second wave of US inflation starts on average 30 months after the first peak. The US is 19 months past the June 2022 peak in CPI.

This inflation data suggests that stagflation could shock the economy in the next 12 months or so.

Get Real About Stagflation

Investors have celebrated the soft landing by gorging themselves on a concentrated group of US stocks, pushing the S&P 500 to all-time highs. The US economy is expanding. The Fed is likely done raising interest rates. Inflation probably peaked 19 months ago. Corporate earnings are growing again. The labor market is strong. There’s much for investors to celebrate.

But, the vigilant investor must always be exploring the risks to the investing environment, especially when the conditions appear to be most bullish or bearish.

How many investors anticipated the treacherous market performance in 2022 or the surprisingly pleasant rebound in 2023? Most investors predicted a recession last year that never happened. Based on last year’s dour forecasts for the economy, many investors missed out on outstanding returns from US technology stocks and high yield bonds. When it comes to investing, the low probability outcome happens far more often than it should.

So, will stagflation occur in the next 12-18 months? That’s out of investors’ control. But what investors can do, is stop underestimating the risks that point to it.

The pace of economic growth is moderating. Restrictive Fed monetary policy will continue to cool the economy. Extraordinary government spending has produced inflation and enormous deficits. Structural supply-demand imbalances in the housing and labor markets are contributing to inflationary pressures. The multi-decade transition from fossil fuels to cleaner energy has been surprisingly inflationary. Deglobalization, protectionism, and geopolitical conflicts might also curb global economic growth while stoking inflation. And, more often, there are multiple waves of inflation.

Despite all this, nobody is talking about the potential future threat from stagflation. That’s exactly why investors should consider the possibility that it could happen.

And, in case you’re wondering, a diversified investment allocation to real assets, including gold, may help to ease the pain from a stagflation outcome.

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