Market Perspectives - Growing Stagflation Chatter Creates Volatile First Quarter

April 2022

  • Global markets experienced their most volatile quarter since the beginning of the pandemic with a host of risks creeping into the investment landscape.
  • Inflationary concerns dominated headlines as prices for virtually all goods and services increased and the Consumer Price Index (“CPI”) rose at its fastest pace in over 40 years.
  • Interest rates also increased rapidly as the U.S. Federal Reserve (the “Fed”) began what is expected to be a lengthy series of rate hikes and other monetary tightening measures to fight inflation. 
  • Geopolitical risks surged during the quarter and Russia’s invasion of Ukraine exacerbated concerns about the supply of key commodities, sending prices higher.
  • Investors weighed these factors against generally strong economic data and pondered the rare but worrisome risk of economic stagnation alongside elevated inflation, a phenomenon called “stagflation.”
 

 “The Fed will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting. Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery.”  
– Fed Governor Lael Brainard on April 5, 2022

 

Summary of Q1 2022:

The first quarter of 2022 was plagued by macroeconomic headwinds and negative headlines. Inflation readings were the highest in 40 years, and expectations of rising interest rates skyrocketed as the Fed hiked the short-term Fed Funds rate target for the first time since 2018. Against this backdrop, the S&P 500 Index declined 4.6% for the quarter, while the growth-heavy NASDAQ saw a greater than 20% intra-quarter decline. The ongoing war in Ukraine created additional uncertainty and added to inflation concerns due to commodity supply chain disruptions. International stocks, particularly those in emerging markets, held up better than U.S. stocks during the interest rate-driven sell-off but underperformed after Russia invaded Ukraine.

This quarter, there was not only a big reversal between the performance of U.S. and international stock markets, but performance across sectors also varied greatly. Energy and utility stocks outperformed until the March 8th bottom, while sectors that had been lagging (e.g., consumer discretionary, technology, and communication services) rebounded strongly toward the end of the quarter. Value stocks strongly outperformed growth stocks through quarter-end.
 

Equity market performance, last four quarters (as of March 31, 2022)

Equity market performance

Volatility was not restricted to equity markets in Q1. Bonds, typically seen as a safe haven when stocks decline, experienced their worst quarterly performance since 1980 as interest rates increased. Long-term U.S. Treasury bonds finished the quarter down over 10%. Commodities rallied on both inflation fears as well as disruptions caused by Russia’s invasion of Ukraine, with the S&P/GSCI index jumping 29%. 
 

Bond market performance, last four quarters (as of March 31, 2022)

Bond market performance
 

Primer on Stagflation

Stagflation is an economic condition in which the economy is stagnant or weak and inflation is elevated. High unemployment and slow/negative economic growth are characteristics of stagflation. The 1970s is typically used as the primary example of this condition.
 
With inflation currently elevated, it is important to understand why rising prices create challenges. The Fed has two primary but at times competing goals: the first is to ensure maximum sustainable employment; the second is to achieve stable prices. We explore these issues below as they relate to avoiding the dreaded stagflation.
 

Employment

The labor market has almost fully recovered from the high unemployment that occurred at the onset of the COVID-19 pandemic. The latest U.S. unemployment reading, released on April 1, was 3.6%. This is generally thought to be at or below the Fed’s target rate for “full employment.” Note that full employment does not mean 0% of the working population is unemployed, as there are always workers in transition. If the unemployment rate falls below what is deemed to be full employment, wage pressure is likely to increase and cause further inflation. Therefore, full employment is always associated with unemployment above 0% that allows for job movement without significant wage pressure.
 
The graph below shows the slow upward creep of average hourly earnings, although it is important to note that wages have not kept up with inflation. This means that workers’ incomes are not increasing in line with the rise in the prices of goods and services. According to a recent LendingClub report, 61% of Americans live paycheck to paycheck. A drop in discretionary income (when household expenses increase more than household income) can be highly problematic for future growth in the U.S. economy, which is largely driven by consumer expenditures.

Average hourly earnings
 

Stable Prices

The Fed’s target for inflation has historically been about 2%, while the past few readings have exceeded 7%. Using a Goldilocks analogy, a “just right” reading would be around 2%. This level of inflation would typically ensure that consumers have a reason to make purchases today instead of waiting, as prices would likely be 2% higher a year from now. An environment of ultra-low (or even negative) inflation could cause consumers to delay purchases to the future, suppressing economic growth. This can be a difficult problem to fix and was one of the Fed’s main worry after the 2008 global financial crisis. In contrast, exceptionally high inflation can cause unstable demand as consumers are uncertain about future costs and wage increases have a hard time keeping up with broader inflation. Consumers may spend less as they attempt to budget for greater uncertainties, which effectively destroys demand, particularly for goods and services that are more discretionary.
 
Inflation is elevated today for many reasons, including a tight labor market, higher commodity prices, supply chain disruptions, and years of easy access to low-cost capital that pushed prices higher. As a reminder, inflation is an increase in prices that weakens purchasing power, negatively impacting consumers’ ability to buy goods and services.
 
Inflation over the past six-plus years, as measured by the annual change in the CPI, is shown in the first graph below. The second graph explains the details of the most recent inflation reading at a more granular level by showing price increases for specific categories of goods. Used vehicles continue to exhibit extreme year-over-year price increases largely due to ongoing supply chain disruptions for inputs for new vehicles (e.g., semiconductor chips), resulting in low inventories in the face of high demand. 

US consumer price

Year over year price increase
 

Achieving the Target Objectives

When one or both of the Fed’s main objectives are not met, the following policy adjustments can be made:

  • Less than Full Employment: When unemployment is too high, the fix is generally to stimulate economic growth. This can be accomplished by lowering interest rates or adding capital to the economy (or both), and by keeping liquidity robust until employment conditions improve. Once the economy is at or near full employment, interest rate policy will be dictated by other factors such as inflation.
  • Price Instability: When inflation is too high, rates can be moved higher to slow growth by slowing borrowing and accompanying spending. Raising interest rates and reducing liquidity in the economy can slow economic growth, which in turn should lower overall demand for goods and services. This typically is one of the main methods of eventually slowing price increases.

 
Monetary policy is often described as a “blunt instrument.” This means that the Fed can not make the economy respond exactly as it intends by changing interest rates; changes in interest rate policy simply increase or decrease liquidity. For example, the significant disruption in the global supply of oil that has resulted from Russia’s invasion of Ukraine cannot be fixed by Fed policy. However, the Fed can make borrowing less expensive or more costly to suit the current environment, thus accelerating or decelerating growth and potentially inflation.
 
At its meeting on March 16, the Fed announced the first interest rate hike of this cycle. The markets are currently projecting a lengthy and steep path of future hikes, as shown in the graph below. The goal is to slow economic growth and subdue inflation while trying to avoid a recession.

Fed funds midpoint

At a high level, stagflation is persistently high inflation alongside weak economic growth and high unemployment. If history is a guide, by raising interest rates now, the Fed will likely cause economic growth to slow. If this slower growth does not also bring down the growth in prices, the result would be stagflation, and the Fed would have a true dilemma on its hands. The monetary policy tools typically available to the Fed might not solve these issues in the short run, because supply chains have yet to normalize and may not for quite some time. This risks a slower-growing economy, which could be put an even bigger squeeze on consumers.
 
Fortunately, for the time being, the economy can likely withstand some level of rate hikes due to the historically low levels at which rates currently stand alongside a very strong labor market. Present conditions do not suggest a recession in the near-term, mainly due to the labor market’s strength. We will be watching economic conditions closely as the year progresses and will adjust expectations, and possibly portfolio allocations, accordingly.
 
The team at BDO Wealth remains focused on the risks and opportunities that will define the year ahead. We would be happy to provide additional perspective on the key themes driving markets today. Please reach out to your BDO Wealth Advisor if you have any questions.