A whiff of stagflation

Stagflation has become a hotly debated topic as inflation expectations rise and growth expectations fall. Stagflation, a hybrid of stagnating growth and rising inflation, would be an unwelcome environment for investors and policy makers alike. While we do not believe that stagflation will dominate the economic environment, monitoring the path of inflation and growth is crucial to asset allocation.

Stagflation is commonly associated with the 1970s, a period of rising inflation, rising unemployment and falling growth linked to an oil price shock. The sharp restrictions imposed on the supply of oil led to a destruction in demand, simultaneously pushing inflation higher and halting economic activity. There are similarities to what is being experienced today as supply chain bottlenecks and rising energy price fuel inflation and weigh on the economic outlook. But this is where the similarities end as the outlook for the global economy is at a point where growth expectations may start to stabilize and inflation rates decelerate.

Stagflation no, inflation yes. There is clear evidence that supply has been limited across many aspects of the economy. Manufacturing and construction sectors have been highlighting the difficulties in sourcing inputs and the record slow delivery times exacerbated by deficiencies in international shipping and overland transport.

Demand for goods, particularly consumer goods, has been high given large parts of the global population has been restricted to working from home and unable to spend on tourism or leisure activities. The excesses in goods demand has come at a time when output in many of the world’s factories was running well below normal levels of capacity due to COVID-19. Semiconductors are a perfect example of where supply could not increase fast enough to satisfy demand.

However, the high rates of inflation caused by these disruptions will moderate as the factors that created them fade. The economics of re-opening should see both an increase in supply as output in the world’s factories increases and demand for goods falls as consumer spending shifts to services. The bottlenecks in shipping logistics may take longer to rectify but again will slowly ease as COVID-19 restrictions around ports are lifted and backlogs are cleared.

Stagnation no, moderation yes. As the economy shifts from the recovery or early phase of its cycle to the middle of it, the pace of economic growth will naturally slow. A move to mid-cycle should not be confused with the start of a down-cycle and while rising energy prices and supply disruptions pose downside risks to growth, this is some way from a recession.

In the near term, many economies are likely to experience an above trend pace of growth as they recapture the remaining lost output from the peak COVID years. We see economic activity being supported by elevated savings rates and healthy household balance sheets in many developed economies, where consumption and spending should increase as economic restrictions are further eased and pent-up demand released. On the corporate side, capital investment has increased at a much faster rate out of the most recent recession than compared to the periods following the global financial crisis or bursting of the dot-com bubble, adding another pillar to the growth outlook.

The inflation outlook is not certain and decarbonization policies and weather disruptions which are squeezing energy prices are only adding to the range of outcomes (see chart). Still, we believe that many of the factors lifting prices in year-over-year terms will prove to be transitory but not all of them, and the underlying rates of inflation are likely to settle in a range close to, if not above central bank targets. Tighter labor markets and higher wage growth are key in the medium-term inflation outlook. Inflation expectations have been rising and have the potential to become self-fulfilling, a departure from the prior decade where wage growth was stunted and the risk to inflation was to the downside.

Investment implications

Investors should not position for an extended period of low growth and high inflation, but be mindful of the transition from early- to mid-cycle and the likelihood that inflation rates will be relatively higher than they have been used to. The positives from both household and corporate spending as well as the fading impacts of COVID-19 on the global economy build a strong case for earnings growth to support equity returns, particularly in cyclical and value-oriented sectors.

Fixed income investing has become no less challenging and will require a more active approach as bond yields rise in response to better growth, steadier inflation and policy normalization. The policy tools of central banks were not designed to deal with supply shocks to the economy, a learned experience from the 1970s episode where central banks tightened aggressively to control inflation. Today, central banks are more likely to look past these shocks and assess the potential for damage to the demand side of the economy when considering the appropriate policy response. The deeply negative real yields on core government bonds makes being overweight duration an unappealing prospect, and even with rate normalization, real rates may remain negative for some time. Credit markets provide a source of income but tight spreads limit capital returns.