That '70s investing show: should we be afraid of stagflation?
Endowus Insights

Leap into prosperity this CNY 💰     Get an $88 head start to growing your wealth.

Leap into prosperity this CNY 💰Get a $88 head start to growing your wealth.

That '70s investing show: should we be afraid of stagflation?

Nov 2022
May 2022
stagflation, inflation, investments

Our thoughts:

It is little surprise that the word “stagflation” is trending as the world grapples with the possibility of both slower economic growth and higher inflation. But there are two reasons why stagflation in the United States is unlikely.

Since the fighting began in Ukraine, bond yields in the US have moved and equities have trailed off globally. The Federal Reserve Bank of Atlanta’s “GDP Now” forecast plunged to predict zero growth in the first quarter of 2022. Simultaneously, inflation rages and is likely to be pushed higher by surging global energy and commodity prices owing to war, sanctions, and the threat of supply disruptions. It is little surprise that the word “stagflation” is trending as the world grapples with the possibility of both slower economic growth and higher inflation.

Supply is usually the culprit, not demand

The combination of higher prices and lower output generally arises from an adverse supply shock. That’s what happened in the 1970s, when twin oil embargoes in 1973 and again in 1979 stalled growth and pushed up prices. Something like that could happen again, if sanctions or acts of war disrupt the flow of Russian or Ukrainian oil, gas, wheat, corn and other commodities worldwide.

Higher prices would reinforce a demand-driven surge in prices and wages already underway before the invasion. Accelerating inflation followed an unprecedented peacetime fiscal expansion in 2020–2021 that coincided with sluggish production, distribution and labor supply responses owing to pandemic disruptions. Inflation has also been exacerbated by a shift in consumer spending from services to goods that caught producers off guard.

US inflation is rising, but unlikely to lead to stagflation

There are two reasons why stagflation in the United States is unlikely. The first is that adverse supply shocks are only a part of why inflation is now high. Excess demand is a bigger part of the story, and demand is already slowing. As it does, price and wage pressures are apt to abate.

The second reason is that an adverse supply shock cannot create sustainably higher inflation by itself. Either it must unleash a wage-price spiral, or it must prompt central banks to ease and over-stimulate demand.

Readers may be puzzled — aren’t prices and wages going up already? Yes, they are. But the key is understanding the difference between a one-time “shock” of demand exceeding supply — which is what the United States and much of the world economy has recently experienced — and an ongoing spiral of prices, which can only result from persistent ongoing increases in demand greater than supply. The latter leads to ongoing inflation. The former to a temporary period of price increases that, on its own, will plateau.

So why is demand unlikely to outstrip supply? One key reason is a collapse in purchasing power. In Exhibit 1, wage growth adjusted for inflation is falling rapidly, the worst period of real wage decline in a quarter century. This past Friday’s US February employment report provided further evidence — average hourly earnings are not keeping pace with rising prices.

Some observers might counter that workers will step up their demands for higher wages. That might happen, but a return to 1970s-style wage-price spirals seems unlikely. Unionisation rates have plunged in the past half century, eroding collective bargaining power of workers. Automatic cost-of-living adjustments are a distant memory. Also, surveys and market indicators show that long term inflation expectations are not consistent with a broad-based anticipation of durable higher inflation. If households and investors believed that a wage-price spiral was likely, long-term inflation expectations would surely be rising.

US wage growth in excess of CPI

Another reason why inflation expectations have not moved much is that the 2021 spending boom has peaked. Household savings have fallen back to pre-pandemic levels, suggesting that “pent-up” demand is receding. Meanwhile, last year’s COVID-19-relief checks, child tax credits, and healthcare spending surges are over. Last year’s government spending is not being repeated this year. Fiscal stimulus is rapidly becoming fiscal drag. In the United States, fiscal policy could lop off at least percentage point from gross domestic product growth this year.

In short, neither precondition for the inflation side of stagflation is probable. Demand appears unlikely to outpace supply on a recurring basis. And a wage-price spiral appears unlikely.

Europe faces more uncertainty

In Europe, the situation is different. Unlike the United States, Europe is a major energy importer, both for crude oil and natural gas. Gas storage was already at low levels going into this crisis (Exhibit 2), creating conditions where higher prices will unambiguously dent European household purchasing power and hence overall demand. Europe’s reliance on Russia and Ukraine for key agricultural commodities and metals could also impact input costs for businesses across multiple industries, further impacting inflationary pressures. For all those reasons, the downside risks to growth in Europe are significantly higher than those in the United States. And, like the United States, measured inflation is being boosted by one-time supply shocks, above all coming from commodity prices.

Europe: fill levels at gas storage st

Slowing growth is the risk China is focused on

China has experienced slowing growth in recent years, accelerated by zero-Covid policies and rising input costs, especially commodity costs, that have not been passed to the consumer over the past two years. Exhibit 3 highlights this bifurcation between inflation being felt by individuals versus businesses. Domestically, China remains hamstrung by property market excesses, many of which resulted from past lax borrowing standards and poor investment decisions. At the same time, the Chinese leadership has expressed its displeasure with growth that risks falling below 5%. If US growth cools this year and Europe’s recovery stalls, China’s export engine will not likely be sufficient to meet Beijing’s overall growth objectives.

China- Producer vs consumer price inflation

Focus on central bank responses

What does all this mean for monetary policy and interest rates?

Despite slowing growth and rising uncertainty, the Federal Reserve (Fed) remains committed to tightening US monetary policy. To be sure, Russia’s invasion of Ukraine has changed the calculus about how fast the Fed will move.

While higher oil prices will probably weaken US growth via falling real wages in 2022, the impact will likely be smaller than during the 1970s oil embargoes when the United States was a major energy importer and energy was a larger part of the economy.

The European Central Bank (ECB) faces a bigger challenge about what to do. Its mandate is singular — keep inflation low. But it cannot realistically ignore that war and surging commodity prices imperil any economic recovery. European countries may boost defence spending, but that impact won’t be felt for quarters or perhaps years. Accordingly, the ECB will be hesitant to follow the Fed’s rate hiking cycle, even if reported inflation remains above the ECB’s target.

But perhaps the most interesting central bank to watch this year will be the People’s Bank of China (PBOC). The reverberations of Russia’s invasion, coupled with the end of Western fiscal stimulus is pushing the PBOC to buck a global tightening trend and ease monetary policy in 2022. Global growth, which in the past two years was held up by western fiscal stimulus, may be shifting again eastward, as China moves to prop up its economy.

The bottom line is that investors should avoid being swept up in discussions about stagflation. It is a term more prevalent in the media than economics, and for good reason. Instead, astute investors will focus on how central banks respond to the shifting fortunes of the world economy and the jolt delivered by war. Their actions will drive developments in global bond markets and, hence, across all portfolios.

This article was originally published by Franklin Templeton, one of the world’s largest asset managers with more than seven decades of experience.


Franklin Templeton disclaimer

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.


Endowus disclaimer

Investment involves risk. Past performance is not necessarily a guide to future performance or returns. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund.

Any forward-looking statements, prediction, projection or forecast on the economy, stock market, bond market or economic trends of the markets contained in this material are subject to market influences and contingent upon matters outside the control of Pte. Ltd (“Endowus”) and therefore may not be realised in the future. Further, any opinion or estimate is made on a general basis and subject to change without notice. In presenting the information above, none of Endowus Pte. Ltd., its affiliates, directors, employees, representatives or agents have given any consideration to, nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons. Therefore, no representation is made as to the completeness and adequacy of the information to make an informed decision. You should carefully consider (i) whether any investment views and products/ services are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances. You may also wish to seek financial advice through a financial advisor or the Endowus platform and independent legal, accounting, regulatory or tax advice, as appropriate.

Investment into collective investment schemes: Please refer to respective funds’ prospectuses for details of the funds, their related fees, charges and risk factors, The listing of units of the fund on a stock exchange does not guarantee a liquid market for the units. Before making an investment decision, you are reminded to refer to the relevant prospectus for specific risk considerations.

For Cash Smart Secure, Cash Smart Enhanced, Cash Smart Ultra: It is not a bank deposit and not capital guaranteed, and is subject to investment risks, including the possible loss of the principal amount invested. Investment products are not insured products under the provisions of the Deposit Insurance and Policy Owners Protection Schemes Act 2011 of Singapore and are not eligible for deposit insurance coverage under the Deposit Insurance Scheme. Interest rates are indicative and subject to change at any time.

Product Risk Rating: Please note that any product risk rating (the “PRR”) provided by us is an internal rating assigned based on our product risk assessment model, and is for your reference only. The PRR is subject to change from time to time. The PRR does not take into account your individual circumstances, objectives or needs and should not be regarded as advice or recommendation to purchase, hold or sell the any fund or make any other investment decisions. Accordingly, you should not solely rely on the PRR in making your investment decision in the relevant Fund.

This advertisement has not been reviewed by the Monetary Authority of Singapore.

More on this Tag
stagflation, inflation, investments

Table of Contents