Financial markets are caught up in a tug of war between lingering inflation and concern about a recession as they try to guess the next move by the Federal Reserve. That means investors are potentially ignoring a far more dangerous outcome: stagflation.
It’s what some economists are calling “stagflation-lite” and it represents a disturbing macroeconomic backdrop for fund managers still licking their wounds from 2022’s brutal beatdowns for stocks and bonds alike.
Chart
Bloomberg Economics sees growing stagflationary risks, dubbing it “stagflation-lite,” and the government’s initial estimate of economic growth in the first quarter supports their case. Gross domestic product rose at an annualized rate of 1.1% in the January to March period, the Bureau of Economic Analysis said on April 27. That trailed the median economist estimate in a Bloomberg survey and marked a slowdown from the prior quarter’s 2.6% increase. Meanwhile, the Fed’s preferred core gauge of inflation, which excludes food and energy, picked up to 4.9% in the first quarter.
That highlights the risk of mispricing in short-term interest rates market, which are pricing in one to two quarter-point rate cuts by the end of this year.
“The kind of stagflationary environment I am seeing in my outlook at the end of this year and also 2024 would be something like where growth is between zero and 1%, closer to zero, and yet inflation would be above 3%.”
Read More: Mispricings Everywhere as We Enter Stagflation-Lite: MacroScope
Yet the curve has been re-steepening, with the gap narrowing since reaching as much as 111 basis points on March 8 — the deepest inversion since the early 1980s — as the struggles of some regional banks reinvigorate concern about a US recession and fuel speculation of Fed rate cuts.
Some investors are turning to precious metals as a haven. Matthew McLennan, co-head of the global value team at First Eagle Investment Management, said the firm has around 15% of its global portfolios in a combination of bullion and gold miners as a potential hedge for inflation and a swoon in the dollar amid concerns of “broader systemic distress” in markets.
Gold will “provide resilience in our portfolios,” McLennan said. “We have also been trying to emphasize companies that control scarce real assets, or at least have entrenched market-share positions. These are companies that ought to be able to generate more cash flow in a down cycle.”
Raw materials overall performed well in past stagflationary regimes, with the Bloomberg commodity index jumping more than sevenfold between the end of 1970 and December 1980. Real estate did well also, with the total return on the FTSE NAREIT All-Equity REITS index at around 188% from the end of 1971 to the end of 1980.
At PineBridge Investments, Michael Kelly is bracing for a US recession on the horizon even as inflation remains high. The global head of multi-asset portfolios said he is underweight US equities and holds high-quality US debt. He’s favoring emerging markets, especially China.
Japanese investors, long among the biggest foreign buyers of Treasuries, started piling back in to US debt this year after dumping it last year. Kiyoshi Ishigane, chief strategist and chief fund manager at Mitsubishi UFJ Kokusai Asset Management Co., shifted from underweight Treasuries to a neutral position once it was clear inflation had peaked in the US.
Chart
“Stagflation is looming,” said Bruce Liegel, a former macro fund manager at Millennium Partners LP who’s been working in financial markets since the early 1980s. He advised buying short-duration Treasuries, such as the 2-year note. Rates are high now and will remain high at maturity — so investors can pick up new debt at that time at even higher rates. He also expects value stocks to outperform growth during this time as well.
“We are set to have higher rates, and higher inflation for at least three to five years,” said Liegel, who writes a monthly global macro report. “The growth we had seen in the past was based on low interest rates and leverage. And now we are unwinding all that, which is going to be a headwind for growth for years.”