An Inflation Shock Sinks the Stock Market: What Investors Need to Know

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From Wall Street to Main Street, fears that the US economy is sliding into 1970s-style “stagflation” have spread.

References to the delicate situation have appeared in headlines all week. The Associated Press called it “the dreaded ‘S’ word”. The Wall Street Journal reminded readers of the origins of the neologism as a catchy way to describe an environment of slowing or stagnating economic growth, job losses and inflation.

The World Bank also referred to it, warning on Tuesday of a “prolonged period of weak growth and high inflation”, while announcing that it had just reduced its outlook for global economic growth by almost a percentage point. .

Then things really came to a head on Friday. May’s reading of the U.S. Consumer Price Index – a closely watched indicator of pricing pressures in the economy – deflated hopes on Wall Street and Washington, DC, that inflation had already hit a low. “peak”. Instead, the headline inflation figure for May came in at 8.6% annualized, a new cycle high.

Lily: Rising rents, gas and food prices push US inflation to 8.6%, its highest level in 40 years, according to the CPI

Many economists were quick to note that the United States had not quite entered stagflation yet. Not with the still extremely robust job market. The US economy also contracted in the first quarter, but few expect that to happen again in the second quarter.

Given the warning signs, it’s important to know how stagflation could affect portfolios and savings.

The bottom line is: from SPX stocks,
-2.91%
with gold GC00,
-0.02%,
If stagflation becomes a reality, investors have very few options available to hedge against the backlash, according to a handful of economists, portfolio managers and market experts.

Why should stagflation be a concern?

Stagflation concerns often focus on the inflation side of the equation. As Friday’s CPI figure confirmed, the pace of inflation accelerated in May to a new cycle high.

The data sparked a flurry of backlash from economists, including teams from Capitol Economics, Barclays and Jeffries, who suggested the Federal Reserve could choose to raise the federal funds rate by 75 basis points when its policy development council will meet next week, or possibly at the next meeting in July.

Others ridiculed the notion of “peak inflation,” the idea that price pressures peaked in March and then began to ease in response to Fed action. The Fed’s first key rate hike since 2018 took place in March, but was followed by much higher interest rate plans this year.

The CPI data was not alone in terms of alarming data points released on Friday. The University of Michigan consumer survey also showed that consumers are even more pessimistic today than they were during the depths of the financial crisis.

As for the pace of economic growth, there are signs that the US economy could be heading towards negative growth in the first half of the year. The Atlanta Fed’s GDPNow forecast predicts economic growth of 0.9% in the second quarter, following the 1.5% contraction in the first quarter.

Most economists define a recession as two consecutive quarters of economic contraction, so even if the Atlanta Fed’s forecast came true, the United States would technically not be in a recession, even if the economy ends up contracting at the during the first part of the year.

What the labor market says

Employment remains the only bright spot in the economy at the moment: the unemployment rate remained at 3.6% in May, as the US economy added 390,000 jobs.

Even so, the rising cost of consumer goods is taking its toll. US revolving consumer credit – essentially a gauge of credit card usage – soared to near-record highs earlier this month.

“Is this a sign of consumer health – or rather a consumer screaming in late-cycle pain as their incomes are crushed by the cost-of-living crisis?” Albert Edwards of Societe Generale asked in a recent note to clients.

Tom Porcelli, US economist at RBC Capital Markets, agreed that could be a concern. “There’s been a pretty rapid acceleration in the use of credit, I don’t think that’s a good development,” he said in a phone call with MarketWatch.

Related: Why ‘explosive growth’ in US consumer debt could return, researcher says

Yet it will take more than just rising inflation and slowing economic growth: The US labor market is also set to take a hit, sending unemployment back closer to 5%.

If the Federal Reserve continues to raise interest rates and exogenous factors like the war in Ukraine and high commodity prices CL00,
-0.15%
continue to drive up commodity prices, eating away at corporate earnings, it is possible that corporate America will be forced to start making budget cuts. Only then will economists generally agree that “stagflation” has arrived.

How might the markets react?

The most difficult aspect of positioning a portfolio for this type of environment is that stocks and bonds are unlikely to perform well.

In a stagflationary environment, you essentially have a recession, which is negative for consumer demand and corporate earnings, and high unemployment, which could impact retail flows into equities.

On the fixed income side of the equation, stubbornly high inflation could force the Federal Reserve to keep interest rates high as it tries to ease price pressures. Rising inflation expectations often force the term premium, that is, the amount required by investors to compensate for the risk of holding longer-dated bonds, to rise.

Mark Zandi, economist at Moody’s Analytics, pointed out in a recent research note that the term premium on long-term Treasuries exceeded 5% during the stagflation wave of the 1970s and early 1980s. currently, the Treasury yield TMUBMUSD10Y,
3.163%
The curve is essentially flat, which means that prices for longer-dated Treasuries would have to fall significantly and yields rise if this type of environment were to materialize.

“There really is nowhere to hide,” said Mohannad Aama, portfolio manager at Beam Capital Management.

In the past, GLD gold,
+1.34%
has been investors’ preferred haven during turbulent market times. Gold recorded its best day in a week or so on Friday, despite initially falling to its lowest level in three weeks after Friday’s CPI report.

Although, near $1,875.50 an ounce, futures for the yellow metal were still more than 8% below the year’s high of $2,040.10 in March, according to Dow Jones Market Data. , leaving many investors disappointed with its performance since the start of 2022. Still, the shiny metal has held its value better than stocks.

TIP Inflation Protected Treasury Securities,
-0.44%
are an option for investors looking to protect their money from the ravages of inflation. TIPS, as they are known, saw their returns end at the highest level since March 2020, according to data from Tradeweb.

As a stagflationary environment approaches, it would also be reasonable to expect the US dollar to continue to strengthen as interest rates rise.

But once stagflation sets in, the Fed will likely be forced to make a choice: does the central bank keep raising interest rates to fight inflation, or do Fed officials cut rates? to try to revive the economy?

In this scenario, Steven Englander, Global Head of G-10 FX Research at Standard Chartered, expects them to choose the latter.

“I think the Fed will compromise in this world,” he told MarketWatch.

US stocks ended the week sharply lower on Friday, falling after the release of inflation data. The S&P 500 SPX index,
-2.91%
fell 5.1% for the week, posting its largest two-week percentage decline since March 27, 2020, according to Dow Jones Market Data. The Dow DJIA,
-2.73%
fell 4.6% for the week, while the Nasdaq Composite Index COMP,
-3.52%
lost 5.6% since Monday.

Looking ahead, it’s a busy week for US economic data. But all eyes will be on the Fed’s two-day policy meeting, which ends Wednesday, followed by Fed Chairman Jerome Powell with a press conference at 2 p.m. ET.


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