Here’s the threat to markets if investors ignore the risk of ‘non-trivial’ stagflation

Financial market participants have completely missed the non-transitory nature of inflation over the past year, failing in what one portfolio manager describes as “dramatically”.

Now, as investors and traders worry about the prospects of a US or global recession, they remain alert to earnings warnings like this one from Walmart Inc., which demonstrate that inflation is taking its toll. But they have yet to come to a full consensus on stagflation, or the unwelcome combination of slowing growth and high inflation seen by many as the worst of all possible outcomes.

“We are concerned that the market is not sufficiently pricing in the tail risk that inflation will continue to surprise on the upside even as growth slows,” said Maneesh Deshpande, managing director and head of US equity strategy and strategy. global equity derivatives at Barclays. “It’s not our base case scenario, but there’s a not inconsiderable likelihood that we’ll enter a 70-style stagflation scenario,” Deshpande told MarketWatch via email.

For now, markets are largely confident that a looming recession in the United States will help bring inflation down and may even put an end to the Federal Reserve’s aggressive rate hike campaign. The so-called peak inflation trade, or the idea that inflation has run its course and is about to come down, is what’s been driving the markets a lot lately: long-term equilibrium rates futures have stabilized in recent days, while yields on Treasuries and inflation-protected securities have been flat since Monday after a few days of declines, according to Tradeweb data.

Gavin Stephens, director of portfolio management at Goelzer Investment Management, said “we’re in a state of stagflation right now, and the market doesn’t seem to appreciate that the Fed isn’t tolerating it.”

“Whether it’s declining market-based inflation expectations or growing confidence in the Fed making a dovish pivot in early 2023, markets seem to have adopted wishful thinking about how the Fed will react to recent inflation data,” Stephens wrote via email.

Key words: Here’s what Bill Ackman says Powell should tell traders about the Fed’s rate hike plans

Much rests on the view reflected in financial markets that lower economic growth should equal lower inflation. Data received shows that parts of the US economy are deteriorating rapidly, and the International Monetary Fund is warning that the global economy faces the possibility of a severe downturn. But inflation has shown a propensity to surprise on the upside, and there is a risk that falling oil and commodity prices will be offset to some extent by rising prices in other categories like housing. , some say.

Investors and traders “are not really talking about stagflation as an economic reality, although that conversation is starting to pick up,” said James Camp, managing director of strategic income at Eagle Asset Management in St. Petersburg, Florida. “The honest truth of all of this is that few financial market practitioners have even dealt with inflation, and an inflationary regime shift is what we are experiencing right now. This is the seismic change that we had to digest during the first half of this year.

“Housing costs are understated and rents are a pain for the average American,” Camp said by phone. “Consumer wages are not increasing. Consumer savings are declining and consumer credit is increasing. The main joker is the labor market. If the labor market cracks, there is no doubt that the consumer will follow.

Overall, “it’s wishful thinking to say that inflation will be in the rearview mirror. There is too much friction in the economy”, and commodities such as oil are “likely to go higher in the second half of the year”. said Camp. He expects the annual headline CPI inflation rate to remain above 6% through the end of the year, from its June level of 9.1%, and to hit again. more shares.

Eagle Asset Management, which manages $32 billion, is a subsidiary of Carillon Tower Advisers, the asset management arm of Raymond James. The strategic income portfolio that Camp manages was 60% risk assets at the end of last year, but has since reduced that allocation to 40%. Eagle Asset is also “constructive on Treasuries, but thinks there’s another leg down for spreads and corporate stocks,” Camp said.

Ahead of the Fed’s rate decision on Wednesday, financial markets appeared to reflect trading mostly in recession, not stagflation: the three major U.S. stock indices DJIA,
-0.71%

COMP,
-1.87%

SPX,
-1.15%
were weaker in the afternoon trade. Meanwhile, Treasury yields were mixed, with the 10-year rate TMUBMUSD10Y,
2.805%
below 2.79%.

Jack McIntyre, portfolio manager at Brandywine Global, said he doesn’t think market participants are underestimating the likelihood of stagflation. He adds that the recent evolution of stock and bond prices more or less recognizes this risk.

Concerns about lingering inflation amid slowing economic growth “is likely a key driver of the recent selloffs we’ve seen across various asset classes (bonds and equities – silver has been just one place to hide),” McIntyre wrote in an email. .

A true stagflation trade would be “to move into cash because stocks and bonds are seeing weaker performance,” McIntyre said. However, “stagflation is not sustainable if the Fed sticks to its primary mandate of breaking inflation”, although “we may have to break the economy to break inflation”.