Stagflation, or high inflation accompanied by low growth, is considered a bane of society as living standards across an economy can be quickly eroded. Therefore, it is not a surprise that high inflation prints and concerns about future growth rates over recent months have resulted in the term stagflation making the headlines. However, we believe the chances of stagflation are low and so should not be the primary concern for investors.
While we are mindful that inflation will be more sustained than central banks are alluding to, we do not think inflation will get out of control. Though the Fed’s latest inflation forecast for 2022 looks ambitiously low at 2.2%, we do expect inflation to gradually come down from the prints above 5% we have seen over the summer as technicals subside and the friction between supply and demand throughout the US economy abates.
Moreover, growth remains extremely strong worldwide. The delta variant of COVID-19 has slowed the reopening of economies, but GDP numbers are still at record levels and forecasters have largely shifted any growth lost this year on to next year’s predictions. This seems a fair assessment – the consumer is still healthy with elevated savings, the labour market is robust with record job openings, and fiscal and monetary policy both remain accommodative. As a result, the IMF expects growth in 2021 and 2022 to be 7% and 4.9% respectively for the US and 4.6% and 4.3% respectively for the Eurozone, levels significantly higher than the average growth numbers seen over the last decade.
In the unlikely event that we do see stagflation though, how might fixed income markets react and how might they want to change positioning? Firstly and importantly we would expect central banks to prioritise growth and employment over combating inflation. If we were to see a dovish shift from central banks in response to stagflation, we would expect a flattening of rates curves despite the presence of higher inflation, and we would also expect credit spreads to remain tight. A logical response to this view from a portfolio perspective would be to take more duration risk while maintaining credit exposures. However, a stagflation scenario would likely see the corporate default rate start to tick higher from today’s very low levels, so reducing credit positions in the lower reaches of the ratings spectrum would also make sense, with the target being a slightly higher credit quality, longer dated portfolio.
It's worth repeating here that we see stagflation as extremely unlikely. Our base case is for a continuation of quite high growth and a modest inflation overshoot. For bond investors, positioning for stagflation as described above could be a dangerous trade if that base case bears out. Longer duration positions would be painful if strong inflation prints put upward pressure on Treasury yields, while the higher quality credit exposure wouldn’t have enough spread to absorb the sell-off in rates.
If on the other hand investors were to position for the base case and we do get stagflation, we actually think the reverse is true. A portfolio positioned for continued growth and higher inflation would likely not be adversely impacted by stagflation, since central banks and governments would likely respond with more dovish policy to try to foster more growth.
So at this stage, while it’s certainly interesting to discuss the prospect of stagflation, positioning for it is actually quite risky. The more likely scenario of a moderate inflation overshoot also happens to be the less risky path from a positioning perspective, and this is the one we think investors should focus on.