It’s time to talk about stagflation, that double-barreled problem of flagging growth and rising prices last seen in the U.S. in the 1970s.
A trifecta of inflation numbers came in hotter than expected this past week, with consumer prices, producer prices, and import prices for July all rising at faster paces than economists anticipated. Notably, consumer prices—excluding the more-volatile food and energy categories—rose at the quickest clip since 1991.
Of course, the increases come off low, pandemic-stricken bases, and compared with a year earlier, inflation is still tame. One month doesn’t make a trend, but this one should turn heads.
Indeed, some see the stronger-than-expected inflation data as welcome news, suggesting the recovery is on track as reopenings continue amid massive fiscal and monetary stimulus. Stock investors took that view after Wednesday’s consumer-price-index report and sent major indexes higher.
The readings also help knock out concerns over a deflationary spiral, in which households and businesses get used to falling prices, cut back on spending, reduce output, and push prices even lower. At the same time, many economists and strategists say some of the price increases behind the CPI’s rise may be transitory. Take the 2.3% month-over-month increase in July used cars and trucks, which can be partly explained by urban flight and an avoidance of public transit as the Covid-19 pandemic lingers.
It’s far too early to be concerned about runaway inflation, says Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. But investors can’t afford to ignore it. “The odds that we see it in 2020, or even 2021, are limited,” he says, “but that doesn’t mean it’s not going to be the next macro trade.”
A few years ago, the so-called reflation trade was all the rage. Investors bet that President Donald Trump’s policies would ignite economic growth, with the trade favoring assets most likely to benefit from an expanding economy and faster inflation. The reflation trade faded well before the coronavirus took hold of the U.S. economy, in part because, by many measures, inflation never really materialized.
Now, a potential reflation looks different and is far less appealing. As David Rosenberg, chief economist at Rosenberg Research, puts it, the inflation that’s coming down the pike carries a big asterisk. “Inflation because of surging demand is almost benevolent,” he says, but what we face is more cost-driven inflation, or stagflation, which occurs alongside weak economic growth. “Stagflation is a nefarious inflationary backdrop,” Rosenberg says, adding that while the Federal Reserve has been eager for inflation to rise, stagflation isn’t the version anyone welcomes.
From Rosenberg’s perspective, stagflation is inevitable, and it may arrive sooner rather than later, since the Fed is all but sure to say next month that it will let inflation overshoot its longstanding 2% target and Washington seems likely to eventually pass another $1.5 trillion or so in fiscal aid.
Rosenberg reminds investors that inflation, stagflation, and deflation alike are a process—one he likens to watching paint dry—and says you can’t squeeze inflation on any sustained basis out of an economy with unemployment where it is.
“I am a believer that the next cycle is one of stagflation, but not today,” Rosenberg says, estimating a three-year runway.
Some say there’s less time. Diane Swonk, chief economist at Grant Thornton, says her base case is that stagflation is a year down the road. She sees more suppliers falling out of the equation, making basics like food increasingly expensive at the same time unemployment remains high and medical costs are rising—especially for the jobless without health insurance.
Investors worried about emerging inflation and the specter of stagflation have plenty of monthly gauges to watch from the Department of Labor and regional Fed banks. Rosenberg suggests a less-commonly referenced metric: changes in the velocity of M2 money supply. M2 is currency in circulation plus saving deposits and certain certificates of deposit and money-market deposits; the velocity of M2 can help tip off investors to inflection points, he says, because it shows how fast money is moving through an economy.
The velocity of M2 money supply fell sharply earlier this year as the economy largely shut down. It remains well below pre-Covid-19 levels, but the gauge bounced in June after hitting the lowest level since at least 1960 in May. A hook upward from here, Rosenberg says, “will be a game changer.”
The investing playbook for stagflation, strategists say, isn’t unlike the one for inflation. Companies that sell inelastic goods and services, such as food-and-beverage and personal-care companies, like
Procter & Gamble
(CL), are good bets; so are oligopolies with pricing power, like
(AMZN). Builders like
(LEN) could benefit because real estate is a hedge.
Looking at the weakening dollar and the potential that it increasingly leads to the U.S. importing inflation (import prices rose 0.7% in July from June), BMO Capital’s Lyngen sees gold, hard commodities, and digital assets as good hedges. Those areas already reflect some investor concern over inflation, if not stagflation, as gold is up 29% this year and Bitcoin is up about 60%.
It’s clear that the demand shock from the pandemic isn’t over. That may last a while, depending on stimulus and a vaccine, but it’s worth remembering that the Fed has less control over the supply side of the economy.
The wrong kind of inflation hasn’t been around for 50 years, but it’s time to start thinking about its return.
Write to Lisa Beilfuss at [email protected]