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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

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“People in their day-to-day life are experiencing higher prices,” not all of which is captured by CPI, Davis said. “The question is whether it’s going to be something that hurts growth or something the market just looks through.”

Oaktree said in its report that “investors don’t appear overly concerned” about rising inflation in the U.S. “But if inflation rates remain high or the global economic recovery wobbles, today’s complacent buyers could quickly turn into tomorrow’s panicky sellers,” the firm said.

Tiffany Wilding, North American economist at PIMCO told MarketWatch that she expects core CPI inflation to be at 4% by the end of this year, falling closer to 2% at the end of 2022. Her forecast is for the U.S. economy to grow 7% in 2021 and then “settle down” to about 3.5% by the end of next year.

“We think goods demand has peaked,” Wilding said. “And as that demand recedes in the back half of the year, you will see inflation coming down.”

While Wilding does not expect to see stagflation, she said that it’s something that could potentially emerge through supply-chain shocks in an environment where a rise in Covid cases “knocks out production” in the U.S. or among “our trading partners.” 

Investors don’t have to be convinced of stagflation to begin thinking about protecting their portfolios through diversification, which could include some exposure to treasury inflation-protected securities, or TIPS, according to Davis.

Investors may meanwhile be studying the trajectory of the yield curve for the bond market’s take on growth and inflation. 

“It may be too much to say the flattening of the bond yield curve is the market pricing stagflation,” said Chris Weston, head of research at Pepperstone, in a recent note, describing that scenario as the “worst backdrop” for equity and risk assets. “But it can’t be far off the mark,” he said. 

In his view, the flattening of the curve “clearly portrays inflationary pressures sticking around” longer than many policymakers had expected. “A normalisation of central bank policy into a period of slower growth is one risk assets do not enjoy – when in doubt, take risk off the table,” he wrote.

This week all eyes will be on the Fed as it will hold a two-day policy meeting that will conclude with Chair Powell speaking at a press conference on Wednesday July 28.

Investors will also be watching for the first reading of second quarter U.S. GDP on Thursday which is expected to accelerate to 8.4% annualized from 6.4% in the first quarter. Data on core inflation, and personal income and expenditure for June is also due Friday.

See: Fed to tiptoe towards tapering next week

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