Investor fears of stagflation risk turning into a self-fulfilling prophecy
- The narrative of a return to high prices and low growth may appeal to markets spooked by a supply chain crisis and China’s growth scare, but it’s not supported by current economic conditions
Financial market commentators and investors love to pin tidy narratives to confusing shifts in the economy and asset prices. Stories matter hugely in markets, mainly because it is easier for traders and analysts to make sense of complex data by turning them into a compelling narrative.
More worryingly, it has become a popular search topic on the internet. Globally, searches for the word “stagflation” on Google Trends are at their highest level since 2008, and are particularly high in Britain, where the term originated and where the current supply chain crisis is most acute.
The speed at which the threat of stagflation has risen to the top of investors’ concerns is striking. As recently as July, nearly half the respondents to Bank of America’s monthly fund manager survey expected global growth to continue to improve.
The publication on Tuesday of the latest poll revealed that the net percentage of respondents anticipating a stronger economy had turned negative for the first time since the eruption of the Covid-19 pandemic. What is more, 38 per cent of respondents believed higher inflation was permanent, up from 23 per cent in June.
Investors are also concerned about the risk of a policy mistake by leading central banks. Bond markets are now pricing in two interest rate hikes in the US by the end of next year despite the fact that growth is decelerating quickly. Having previously feared a repeat of the 2013 “taper tantrum”, markets are now afraid that the Federal Reserve will trigger a recession.
These are all understandable reasons to fret about growth and asset prices. However, shutting down the global economy was always going to be easier than restarting it as the virus continues to rage and the engines of economic activity take time to operate normally again.
Although the stagflation narrative captures the fears of many investors, it is an inaccurate depiction of what is happening in the economy and markets today. It also risks becoming a self-fulfilling prophecy that could cause sentiment to deteriorate more sharply than warranted by the data.
The “stag” in stagflation fears has more to do with the fact that the world economy, while still expanding at a brisk pace, is no longer growing as fast as markets expected earlier this year. Citigroup’s global economic surprise index – which measures whether data is beating or falling short of analysts’ expectations – has been in negative territory since August.
Second, while it is clear that inflationary pressures are more persistent than anticipated, the surge in prices is mainly attributable to broken supply chains, as well as energy and food price shocks resulting from the pandemic. While these pressures are intense, they are not demand-driven and are likely to fade before they become embedded in long-term inflation expectations.
Just as importantly, unlike the 1970s, organised labour is much weaker today, while central banks are much less tolerant of inflation, making a permanent break from the era of stable prices highly improbable.
Third, while investors are concerned about stagflation, this is not reflected in asset prices. The benchmark S&P 500 equity index is trading within a whisker of its all-time high, buoyed by companies’ solid operating margins in the face of strong price pressures.
What is more, bond yields, while having risen significantly over the past month, remain at historically low levels. Indeed, concerns about slower growth are helping keep a lid on yields, allaying some of the fears about higher inflation.
The stagflation narrative may be popular among investors, but it is a misleading characterisation of both the state of the economy and investor positioning. Stories are appealing to investors, but they can also be just plain wrong.
Nicholas Spiro is a partner at Lauressa Advisory