Stagflation…Should You Be Worried?
Stagflation. Its mere mention sends shivers down the spine of anyone old enough to remember the double-digit inflation, high unemployment, and endless gas lines of the 1970s and early-1980s. Ultimately, draconian measures by the Federal Reserve under then-Chairman Paul Volcker successfully wrung inflation out of the economy but not before a sharp rise in interest rates and a painful recession.
In the four decades since, inflation has generally been an afterthought, occasionally exceeding its long-term average of 3% and even falling below 2% for most of the last ten years. Then, in early-2021, the vaccine rollout and the broader reopening of the US economy caused a supply-demand imbalance which pushed inflation above 4% for the first time since 2008, above 5% for the first time in nearly twenty years, and most recently, to 6.2% – the highest level since November 1990. The sudden uptick in prices set off alarm bells that stagflation, that bogeyman of a bygone era, might make its return.
What is stagflation?
Simply put, stagflation is persistently high inflation accompanied by stagnant economic growth. Inflation can be caused by excess demand or by a supply-side shock. In the 1970s, OPEC cornered the oil market and instituted an embargo that caused an oil shortage and an increase in global oil prices. Because the US was heavily dependent on Middle East oil back then, the oil shortage and higher gas prices not only caused inflation to spike but led to an economic slowdown as well – stagflation.
A big difference between now and then is that the US is no longer beholden to foreign oil, having achieved energy independence in the past decade-plus. So, even when oil prices do go up (currently over $80/barrel), while headline inflation (core inflation plus food and energy) will also increase, the impact on the US economy is far less than experienced in the 1970s.
What is causing today’s inflation?
Unlike the 1970s, today’s inflation is not the result of a supply-side shock but rather stronger-than-expected demand rapidly depleting existing supply with companies unable to replenish that supply fast enough to keep up with the strong demand. Certainly, there are supply chain issues (China, Suez Canal, etc.) that have also led to decreased supply. However, it is excess demand rather than supply that is truly driving the inflation bus. To prove this, one must look at corporate profitability and labor productivity. If this latest inflation were the result of a 1970s-style supply-side shock, both profitability and productivity would be falling. We are seeing the opposite occur. Corporate earnings are robust, and productivity is enjoying a post-COVID boom.
Are you suggesting the recent bump in inflation is purely transitory?
Most indications suggest yes. Eventually, the supply-demand gap will close and find an equilibrium. However, that could take longer than expected to happen, which means higher inflation might persist for some time. Even if that were to be the case, long-term inflation expectations remain muted, suggesting that economists and professional forecasters are not overly concerned with inflation in the long run.
What does the market think?
Investors seem to be more concerned about persistently high inflation than the so-called experts. Is it possible the economists and professional forecasters are wrong? One way to understand investor sentiment is to observe bond yields. If the market were concerned about persistently high inflation, we would expect to see an increase in bond yields because higher inflation would likely compel the Federal Reserve to increase rates sooner. And even though the Fed has stated it has no intention of raising short-term rates until mid-2022 at the earliest, Treasury yields have trended higher this year. The 10-year Treasury yield opened 2021 at 0.93% and reached a peak of 1.68% in late October before finishing the month at 1.55%. And while the increase in interest rates has put pressure on bond returns, the stock market has thus far shrugged off concerns that higher inflation will be accompanied by an economic slowdown, putting downward pressure on corporate earnings and stock prices.
One other thing at work here is investor behavior. According to Bloomberg, the number of news articles mentioning stagflation has increased by 300%! So, it is possible that investor anxiety is more driven by stagflation on the brain rather than actual stagflation.
Perspective is important
Long-term perspective is important as well. The recent bump in inflation follows a very long stretch of below-average inflation. And even if we were to experience higher prices for an extended period, it is no reason to suddenly change one’s investment strategy. Stocks have proven to be the best hedge against inflation. Bonds, while facing the headwind of higher interest rates, still are an important component of a portfolio because they balance out the risk of stocks. And other purported inflation hedges like TIPS and gold have historically not done the job.
As a member of the Investment Committee, Matt is instrumental in developing BDF’s overall investment strategy. Matt received his Bachelor of Science in Economics with concentrations in accounting and finance from the Wharton School of the University of Pennsylvania and his MBA in finance and strategic management from the University of Chicago Booth School of Business.