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How worried should we be about stagflation?

May 2022

The rise of inflation to multidecade highs has prompted a swift reaction from central banks, with both the U.S. Federal Reserve (Fed) and Bank of Canada (BoC) initiating 50-basis-point rate hikes and indicating more to come over the next several months.


But with the economic growth picture increasingly cloudy due to factors such as the war in Ukraine and the re-imposition of pandemic restrictions in China, there are growing concerns of a return of stagflation, a challenging economic cocktail of high inflation, weak growth and high unemployment.


As the name suggests, stagflation defines a stagnating economy alongside high inflation. The term gained widespread use during the stagflation crisis of the late 1970s, when the global economy was shaken by soaring prices and sluggish growth.


It is considered a nightmare economic scenario for central banks, as it represents an inversion of the normal relationship between growth and inflation. Typically, high inflation is the result of a strong economy in which overall demand exceeds supply. In that situation, central bankers can raise interest rates, which then cools demand and in turn brings down inflation.


In a stagflationary environment, inflation remains high and acts as a brake on economic growth. As the banks raise rates to bring inflation under control, that puts even more pressure on growth, leading to a situation of still-high inflation alongside a stagnating economy. It is an outcome that the Fed and BoC would desperately like to avoid, but one that is hard to ignore given recent data.


U.S. inflation hit a four-decade high of 8.5% in March, fueled by rising employment costs, higher commodity prices following Russia’s invasion of Ukraine, and pent-up demand stoked by two years of rock-bottom interest rates. In Canada, inflation was 6.7% during the month, its highest level in more than 30 years.


“The enormous amount of monetary and fiscal stimulus that has been pumped into the global economy since the onset of the pandemic has generated inflation that has now reached levels not seen in decades,” said Peter Zaltz, Chief Investment Officer at Gluskin Sheff. “Russia’s invasion of Ukraine has only added to the market uncertainty and has further complicated the inflation picture by pushing many commodity prices up sharply.”

While the Fed, BoC and other central banks are now aggressively tightening, rate hikes often take up to a year to have a meaningful impact on inflation, which means price pressures could persist for at least the remainder of 2022.

The outlook for growth has also become increasingly uncertain, as the war in Ukraine has driven up commodity and food prices, while global trade still bruised from pandemic-specific factors has seen further disruption from both the Ukraine war and from China’s imposition of lockdowns in the trading hub of Shanghai and other cities.


This has prompted some to begin sounding the alarm on the prospect of continued high inflation and a stagnating economy. The World Bank in its April Commodity Markets Outlook called the food and energy price impacts of the war the largest commodity shock since the 1970s. “These developments have started to raise the specter of stagflation,” World Bank Vice President for Equitable Growth, Finance, and Institutions Indermit Gill said in the report.


Europe more vulnerable


The Euro Zone, the area most acutely affected by the Ukraine war, posted inflation of 7.4% in March. Mark Grammer, who manages Gluskin Sheff’s International Equity strategy, says he is concerned that surging inflation will squeeze incomes in Euro areas.


“Europe is more vulnerable to stagflation since the economy will slow down in the face of the declining consumer confidence, but prices will go up in the short run,” he said. “Fortunately, the ECB (European Central Bank) recognized the risk and expects inflation to moderate in the back half of the current year as supply chain disruption eases and hopefully the price of oil and gas stabilizes.”


Indeed, it is the nature of the current round of inflation that makes the potential for stagflation difficult to assess.


While rebounding economic growth—spurred by enormous amounts of monetary and fiscal stimulus—has been the main fuel behind the price gains, it is difficult to predict how long the price pressures from supply-chain disruptions, labour scarcity, the war in Ukraine and the lockdowns in China will persist.


For Shelagh Lemke, Gluskin Sheff’s Managing Director, Head of Fixed Income, a concerning sign would be slowing economic growth alongside continued upwards employments costs. “I think wage pressure is what could keep some of this inflationary pressure alive and could make it a little more permanent,” she said.


As mentioned, the current situation has revived memories of the inflation crisis of the 1970s, when a combination of factors, including heavy government spending, loose fiscal policy, and an oil supply shock pushed inflation into double-digits. While there are evident similarities to the current situation—in particular, soaring energy prices making an already challenging inflation picture worse—Lemke points out that central bankers now have a clearer game plan to deal with inflation than they did in the 1970s. In the early 1990s, for instance, central banks raised rates to the point of triggering a recession to stave off inflation.


“I think there’s an inflation orthodoxy among central bankers and I think we saw that recognition out of the Fed and then later out of the Bank of Canada and ECB that they needed to do something to get inflation under control,” she said. Another difference is that the world is less reliant on crude oil than it was in the 1970s, which suggests better potential for recovery from spiking energy prices.


Anticipating more inflation


In the current situation, Lemke is still of the opinion that supply disruptions will resolve themselves and that central bankers will be able to eventually get inflation under control. However, in managing the Blair Franklin Global Credit Fund, Lemke and Zaltz have situated the strategy to withstand, and even benefit from, the rate hike cycle to come. They are also paying close attention to the forward credit metrics of the companies they invest in, with careful consideration of how they will perform in an inflationary environment.


“We’re keeping in shorter-tenor securities and we’re being more active in our positioning to take advantage of the volatility. We’re also very cognizant of some of these economic risks, whether it’s the risk of stagflation or whether it’s just slower economic growth and continued market disruption due to higher rates or geopolitical events,” said Lemke.


Given recent statements, Lemke expects the Fed and the BoC to err on the side of aggressive rate hikes to curb inflation.


“I tend to not believe in a doomsday scenario. I’m thinking that higher rate and higher commodity prices will slow growth and will also tame some of the inflationary expectations and that traditional tools will work,” she said.


Market volatility


For investors, the possibility of stagflation would mean a continuation of the market volatility of the last few months, with high bond yields and weakness in certain equity sectors as companies struggle to grow revenue and deal with higher borrowing costs.


Rob Fournier, who manages Gluskin Sheff’s U.S. Equity strategy, has increased his defensive tilt as of late partly due to elevated risks of recession. He has reduced holdings of cyclically-sensitive stocks such as semiconductors, industrials, and financials, and has added in healthcare.


Alkarim Jiwa, who manages Gluskin’s Canadian equity strategies, sees fewer stagflationary pressures in Canada than in the U.S. and Europe due to Canada’s relatively robust growth to date. He has focused on companies which have pricing power and can benefit from inflation.


“We are fortunate that many companies in the Canadian equity market, particularly in the commodity-oriented sectors, perform well in an inflationary environment,” he said.


Likewise, Grammer has positioned the international equity strategy to be ready for both higher rates and the potential for stagflation.


“The fund added exposure to energy and basic materials last year, sectors that are beneficiaries of the spike in commodity prices. Additionally, we have limited exposure to consumer cyclicals and the ones in the portfolio are high quality companies with reasonably sound pricing power,” he said.


He also noted that the European equity market has priced in much of the risk already, as it trades at a relatively low price-to-earnings valuation. Asian markets, which the fund has some exposure to, are generally also trading at relative lows, and inflation has been more subdued in markets such as Japan.


“We’re realistic that stagflation and/or a recession would hurt profits and therefore impact the prices of stocks in the near term, but we remain confident that the portfolio will weather the slowdown well and rebound strongly as the storm passes,” said Grammer.

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