Research Affiliates: Stagflation risk is rising
By Chris Brightman, Chief Executive Officer & Chief Investment Officer at Research Affiliates
Investors are repositioning portfolios to protect the real value of their financial capital as equity markets are beginning to price the rising risk of stagflation.
As of mid-June 2022 I see four possible cyclical scenarios ahead.
The nominal 10-year US Treasury yield is 2.9%, and the 10-year breakeven inflation (BEI) is 2.7%, providing a 10-year real TIPS yield of just above zero. The 5-year BEI of 3% assumes that CPI falls toward the US Federal Reserve’s target near 2% soon, given that year-over-year CPI is running above 8%.
If the Fed achieves this benign path for inflation and interest rates without causing a recession, the recent decline in stock prices may be behind us. While the present S&P 500 earnings yield of a little above 4% is well below its long-term average of 7%, it provides a reasonable risk premium relative to long-term real rates of 0%.
The bond market’s pricing might be right but the required tightening, taking the fed funds rate to 3% by early 2023 along with aggressive quantitative tightening may cause a recession. If so, the stock market may price in a higher risk premium until it perceives the end of the recession. Stocks would likely fall further, but valuations may remain within the elevated range we have experienced over the 21st century.
If the Fed fails to tame inflation, stock and bond prices have further to fall. BEI will rise along with nominal interest rates and investors will suffer losses in their bond portfolios. History, and common sense, teaches that high inflation coincides with high volatility of inflation, interest rates, and equity prices. Volatility in capital market prices is like a thermometer displaying an elevated temperature. It reveals a disease. Following this analogy, the disease is flawed economic policy. High volatility raises risk premiums and lowers stock prices.
If the Fed fails to tame inflation and we have a recession or two, expect capital markets to behave as in the late 1970s and early 1980s. Interest rates will soar toward or above the-then current rate of inflation. Equity prices will tank and P/E multiples will contract. In the last period of stagflation, Shiller’s CAPE fell below 10 in 1977, bottomed at 7 in 1982, and failed to rise back above 10 until 1985. With the CAPE well above 30, a fall even to just to 10 implies a frightful decline of stock prices.
Secularly rising real rates
China’s mercantilist growth model, US corporations’ pursuit of monopoly profits through financial engineering and low investment, and underinvestment in public infrastructure across the developed world have all contributed to an excess of desired savings over actual investment.
Three secular forces are increasing the demand for real investment, thereby likely raising the global level of equilibrium real interest rates: increased military spending, reshoring of supply chains and manufacturing capacity, and dramatically increasing investment in sustainable energy.
To control inflation, the Fed may need to raise interest rates above the level of expected inflation. The huge US public debt—now over 120% of GDP versus just over 30% at the end of the 1970s—may not allow a steep rise in nominal rates. Continued money creation may be required to service the debt when interest rates rise, prolonging the inflation cycle.
Implications for investors
I perceive at least even odds the Fed fails to get inflation under control soon. Can a fed funds rate of 3% tame CPI running at 8%? I also see even odds of a recession by year-end 2023 and a one-in-three chance of both events—stagflation—happening.
If I am correct, investors will wish to reposition portfolios to protect the real value of their financial capital, reducing exposure to equity beta and nominal duration by selling mainstream stocks and bonds in favor of commodities and real assets. Investors may protect the real value of their bond principal by swapping out of nominal bonds into TIPS, or floaters. Lastly, investors will flee from longer-duration growth stocks and rotate into lower-duration, and exceptionally cheap, value stocks.
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