Broker Check

Are Stagflation Risks Real?

May 13, 2024

Stagflation has become a somewhat popular topic amongst investors ever since the March CPI report ran hotter than expected and because stagflation is one of the worst possible investing environments for stocks and bond holders. So, I wanted to review the recent data and examine if stagflation risks really are rising. Importantly, most economists are dismissive of this idea of stagflation. Chief among them is Fed Chair Powell, who said in the April FOMC press conference that he didn’t understand stagflation concerns and saw neither the “stag” (meaning stalled growth) nor the “flation” (meaning high inflation).


Of course, comparing this period to the 1970s, where GDP growth was flat or negative and CPI was running more than 10%, he’s absolutely right, there is no stagflation. However, I believe it’s somewhat dismissive to say that just because things aren’t as bad as they were in the 1970s that any talk of stagflation isn’t warranted.


Point being, stagflation doesn’t have to be as bad as it was in the 1970s, but for a stock market that’s trading above 21X earnings, the truth is that even a small bout of stagflation could result in a 10%-20% decline in stocks (because a stagflation multiple is somewhere below 18X, or more than 600 S&P 500 points lower from here). So, with all due respect to Powell and other economists, I do think it’s worth taking a look to see if stagflation risks are rising and, if so, what it could mean for stocks.


First, is the “stag” occurring? In an absolute sense, no it’s not. Q1 GDP growth was solidly positive (even at 1.6% that’s a long way from 0.0% and underlying growth was even stronger). That said, there are several more timely economic indicators that are pointing towards a loss of momentum. The ISM Manufacturing and Services PMIs are now below 50, something that doesn’t happen often. Durable goods, a proxy for business investment, has been essentially flat for over a year. The unemployment rate, while still low, is threatening to move above 4% for the first time in years.


What’s It Means to Me: None of these metrics imply that economic growth has stalled, so Powell is right, there isn’t any hard evidence of an economic stagnation. However, it’s also accurate to say that the data is becoming more conclusive that economic momentum is slowing and that must happen first if any stagnation is going to occur. The bottom line is economic growth is still solidly positive but clearly the momentum is slowing, so while stagnation isn’t here yet, the data is showing a greater chance of it occurring than any time in the last year and a half.


Second, is the “flation” occurring? In an absolute sense, no, it’s not. CPI has rebounded to 3.5% y/y, University of Michigan Inflation Expectations are rising to multimonth highs at 3.5% for one year and 3.1% for five years while price indices in the ISM Manufacturing and Services PMIs have also jumped to multi-month highs. But if our measuring stick is 1970’s style inflation (or even pandemic-era inflation) then no, we aren’t seeing that type of inflation.


What’s It Means to Me: In an absolute sense, inflation isn’t at levels that would imply historical stagflation. But it’s also clear that inflation has stopped declining and at this point appears to be trying to bounce. No one thinks inflation is going to surge back towards 7% or 8% again, but for a market that’s priced at over 21X earnings and counting on lower yields to justify that valuation, the bounce in inflation metrics is a problem.


Bottom line, inflation has declined and isn’t at 1970’s levels, but it’s undeniable that the decline in inflation has stopped and the longer inflation stays higher, the more it will become entrenched in the economy—and that means higher inflation risks. In sum, stagflation is not here, especially if we think about it in 1970’s terms. But the data is moving in a stagflationary direction of 1) Slowing growth and 2) Buoyant prices and with the S&P 500 trading above 21X earnings, we don’t need 1970’s style stagflation to cause a correction—we just need the data to keep going in the current direction because the stagflationary drift in the data is absolutely a worry for anyone owning stocks and bonds, and that’s a critical difference to be aware of (and we are).


We do not feel the need to change anything at this point, until things get worse. I don’t see that happening. The election will begin to affect the market as we get closer to November. I don’t know about you, but it can’t happen too soon for me.

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