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.
Over the past few months, one story has been at the forefront of investors’ minds: the twin threats of accelerating inflation and decelerating economic activity. The dreaded “stagflation” – which has its roots in the aftermath of the 1970s oil shock, which gave rise to soaring prices and economic misery in major economies – is the most talked about risk in markets.
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.
Markets have been spooked by a confluence of alarming trends. The most worrying one by far is the rapid build-up of price pressures. The inflation shocks have been fast and furious, from energy and food to shipping and semiconductors. The severity and persistence of the supply disruptions have made it increasingly difficult to dismiss the surge in prices as transient.
The sharp slowdown in the global economy has undermined confidence further. A growth scare in China – which faces a triple whammy of an energy crunch, draconian restrictions to contain the spread of the virus and a dangerous policy-induced downturn in the country’s all-important property sector – has taken hold just as America’s economy has slowed significantly, with a gauge of consumer sentiment in September plunging to its second-lowest level since 2011.
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.
First, current economic conditions bear little resemblance to the stagflation of the 1970s. The International Monetary Fund expects global growth of 5.9 per cent this year and 4.9 per cent in 2022. This hardly qualifies as stagnation.
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.
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