Should we fear stagflation?

Ever since coronavirus vaccines arrived on the scene more rapidly than expected last year, the hope has been that economies could re-open quickly, households flush with savings would go out and spend, and we’d see a resurgence in growth to match the slide seen during global lockdowns. In the stockmarket, this particular bet was known as the “reflation” trade, with the companies hardest hit by lockdowns rebounding, while other “value” stocks such as miners benefited from surging demand for resources.

However, while growth has rebounded at a rapid pace, there are signs that the recovery might be running out of steam. The latest US nonfarm payrolls figures (a monthly measure of how many jobs are being added to the US economy) was hugely disappointing. And it’s just the latest sign that the Delta variant has thrown a spanner in the works of the re-opening process. As a result, we’re seeing more and more talk of an economic spectre that hasn’t reared its ugly head in 50 years – stagflation.

Stagflation (“stagnation” plus “inflation”) is an unusual and unpleasant condition in which the economy grows slowly or falls into recession, yet inflation stays high and rising. This makes it a central bank’s worst nightmare – they can’t raise interest rates to tackle inflation without squeezing the weak economy further, but they can’t cut rates to try to boost growth without fuelling inflation.

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So is it on the cards? We have argued for some time that we’re moving into a more inflationary world. But we’d hope that this would be combined with strong growth for at least a while. The main risk right now probably stems from any stalling in the re-opening process and employees returning to work. If that happens then activity and growth will take a hit, but supply chain issues will only get worse, partly due to labour market disruption. As Nouriel Roubini argued on Project Syndicate recently, we’re already seeing “mild” stagflation. The misery index (defined below) is running at double-digit levels due to high inflation and still-stubbornly high unemployment, levels not seen persistently since the late 1970s.

One thing is clear – investors should hope we can avoid it. Stagflation is mostly associated with the 1970s oil shocks, but Mark Hulbert in The Wall Street Journal notes that the stagflationary period actually ran from 1966 through to 1982, when then-US Federal Reserve head Paul Volcker helped to kill it off – at the cost of a huge recession – by raising US interest rates to double-digit levels. In that period, US stocks made almost nothing in “real” terms (ie after inflation), bond investors had to be very selective (avoiding long duration bonds in favour of medium and short-term ones), and even commodities – the classic inflation hedge – were mixed. Keep watching the jobs market.