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July 26, 2021, 3:48 p.m. EDT

Stagflation is ‘a legitimate risk’ that would be painful for U.S. markets

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By Christine Idzelis

The possibility of stagflation — an economic environment marked by high unemployment, high inflation, and low economic growth, experienced in the U.S. in the 1970s — has moved onto the radar screen of some market analysts.

“Stagflation is absolutely the biggest risk for every investor,” said Nancy Davis, founder of Quadratic Capital Management, in an interview. It imperils the “magical stock-bond correlation that everyone expects” will keep their investment portfolios diversified should risk appetite fall.

When stocks tumble in times of tumult, bond prices tend to rally as investors pile into them for safety, but a traditional portfolio of 60% stocks and 40% bonds could see a “disastrous outcome” should stagflation show up, Davis warned.

That’s partly because inflation erodes the value of bonds, typically prompting investors to sell and the result is price declines and higher yields.

“Imagine how scary it would be for the market if we had stocks and bonds selling off together,” she said. Stagflation could pose a “major problem because central banks can’t really come to the rescue and cut interest rates .”  

Investors will be closely watching the Federal Reserve’s policy meeting this week, looking for any shifts in the accommodative stance it took toward markets at the onset of the coronavirus pandemic last year. While U.S. inflation has recently surged, Fed Chair Jerome Powell has reiterated that the jump in the cost of living will be temporary as it’s tied to the labor and product shortages being experienced in the economic rebound from the Covid-19 crisis this year.

The Fed has been letting the economy run hot in the meantime, aiming for more progress in the labor market

“I see it as a legitimate risk,” Nathan Sheets, chief economist at PGIM Fixed Income, told MarketWatch, calling the possibility “a pain trade for markets.” Stagflation is not the base case for Sheets, who said he is more concerned about inflation becoming persistently high than about stagnating economic growth. Still, even after a rapid recovery from the Covid-crisis, the U.S. economy is down around 7 million jobs, Sheets said.

In his view, the recent decline in U.S. bond yields is signaling concern that economic growth may have peaked and may stagnate in the medium term, whereas the equity market appears to have “sunnier” expectations. “There does seem to be a disjuncture,” he said, describing the bond market’s outlook as “restrained at best,” while investor enthusiasm in the stock market has pushed major U.S. stock indexes to all-time highs.   

The Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.48% , S&P 500 /zigman2/quotes/210599714/realtime SPX -0.91% and Nasdaq Composite /zigman2/quotes/210598365/realtime COMP -0.91% indexes all closed at fresh peaks Friday , with the Dow closing above 35,000 for the first time, as investors brushed off concerns over the rapidly spreading delta variant of the coronavirus. 

The yield on the 10-year Treasury note /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% settled Friday at 1.286%, down about 1.4 basis points for the week, according to Dow Jones Market Data. That marked a fourth straight week of declines, and compares with a yield of about 1.75% at the end of March. 

“Possible explanations for the rate plunge are wide-ranging,” Oaktree Capital Management said this month in its second-quarter report . “They include investors’ belief that price increases will soon decelerate, strong foreign appetite for U.S. debt,” as well as fears that the delta variant could slow global economic growth, said Oaktree. Another explanation could be that “expectations that slightly tighter monetary policy in the next few years” could lower the probability of “runaway inflation” along with the resulting need for significant interest rate hikes, the report said.

Read: Bond yields and tech stocks echo ‘extreme anomalies’ of dot-com boom, says Morgan Stanley

Daniela Mardarovici, co-head of U.S. multisector fixed income at Macquarie Asset Management, told MarketWatch that stagflation is not her base case but it is “very much on the radar” as “it would be a painful scenario if it happened.” Mardarovici believes inflation shouldn’t “get out of control,” but, she said, “if we keep going into lockdown” then global supply-chain disruptions “might not be all that temporary.” 

Supply chain disruptions also worry Quadratic’s Davis. 

The Quadratic founder sees the risk of stagflation as being partly tied to the “global chip crisis.” A pandemic-related shortage of microchips, which “go into everything” from cars to appliances to phones and computers, is adding fuel to inflation, Davis said. Labor shortages in some industries can also contribute to higher prices, she added. 

The U.S. consumer price index, or CPI, climbed 5.4% in the 12 months through June, with prices rising at the fastest pace since 2008, MarketWatch reported earlier this month.

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