Stagflation: Consequences for Financial Markets

“Get ready for an economic hurricane”, warns Jamie Dimon CEO of JP Morgan. Whether it will be a full-fledged storm or hurricane is, of course, not a foregone conclusion.

And in fact, The world economy is currently experiencing a supply shock that could lead to an economic crisis. In our opinion, a supply shock has six economic effects that can be described as follows:

  1. The increase in the prices of raw materials as a result of the conflict in Ukraine causes an increase in inflation

2. The increase in inflation acts as an “oil tax”. That is, those who spend more at the pump have less money available to buy other goods and services.

3. High inflation, sooner or later, leads to higher interest rates, as we are already seeing in the United States and soon in Europe.

4. Higher interest rates lead to lower investment and slower growth

5. As a result of a supply shock, uncertainty increases in the economy, following rising input costs, supply chain problems, or rising credit defaults, for example

6. An additional possible consequence is a wage price spiral, if unions can impose compensation for rising inflation in the form of higher wages

Slowing growth with high inflation

Markets need to brace for slower growth with high inflation. On both sides of the Atlantic there is an 8 in front of the decimal point: in the US, annual inflation stands at 8.3 at the end of April and in the eurozone, Eurostat estimates annualized consumer price inflation at 8 1 at the end of May 2022. The probability that the United States will experience a recession in the next 12 months has increased recently.

However, it remains at just over 30. In Europe, the economy is cooling more markedly than in the United States. A recession would be inevitable in Europe if an embargo were placed on Russian gas or if Russia cut off supplies.

The current economic situation, with all the differences that historical comparisons always entail, is reminiscent of the situation in 1973-1974, when Arthur Burns headed the Federal Reserve. Burns is now considered too cautious, in part because he bowed to pressure from the US government.

President Richard Nixon, facing new elections, advocated low interest rates. Thus, the Fed raised interest rates too late and too slowly after the first oil price shock, failing to prevent rising inflation expectations from leading to higher wages. The current situation seems similar, as the war in Ukraine is causing an energy price crisis. Brent oil has gone from about $70 a year ago to $120 now, Lofty stimulus measures from Presidents Trump and Biden have fueled inflation.

According to the ‘Taylor rule’, the Fed continues today to act too late and with too much hesitation, since actual inflation is well above target inflation and the US economy is running at full capacity. High inflation will almost certainly force the two main central banks, the Fed and the ECB, to raise interest rates above the neutral rate.

In addition, the Federal Reserve has announced that it will reduce its balance sheet through a quantitative adjustment, thus removing liquidity from the market. Investors would do well to prepare for the end of the era of cheap central bank money. Inflation will likely fall more slowly than central banks on both sides of the Atlantic expected at the beginning of the year, given high energy prices. In our opinion, a short bond duration is still advisable. Short-term interest rates will rise significantly and yield curves will flatten.

Flat or inverted yield curves typically indicate an increased probability of a recession. As the probability of a recession increases, we remain cautious on high yield bonds. In the past, it has proven prudent to invest in the high yield only when the recession has set in and yields have risen sharply. We haven’t gotten to that point yet. Defensive value stocks will likely continue to outperform expensive growth stocks in an environment of rising interest rates.

In the coming quarters, supply chain issues and rising costs could lead to further pressure on margins. Therefore, we focus on investments in companies with high pricing power. We remain fundamentally cautious and keep equity quotes below the neutral quotes agreed with our clients. China offers a first ray of hope. The latest news from the Middle Kingdom indicates that policy makers will take stimulus measures and relax the strict “zero Covid” policy. As I have already said, it remains uncertain whether we can expect a mild storm or a severe hurricane.

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