Unlike recessions during which bonds tend to do well as interest rates fall, rising inflation, together with a surge in unemployment and a slowing economy often erode the value of both stocks and bonds, while also impacting the everyday lives of consumers.
British politician Iain Macleod dubbed this trifecta of negative events - occurring simultaneously - stagflation in the 1960s.
A few short years later, stagflation - driven by a sharp increase in oil prices - underscored what was seen as a lost decade for equities in the 1970s.
Admittedly, stagflation wasn’t seen as an immediate threat at the start of 2025, with global inflation cooling to 3-4% by IMF estimates.
One simple way to measure stagflation is real gross domestic product (GDP) growth below the previous 10-year average and Consumer Price Index (CPI) inflation above its 10-year average.
Stagflation conditions rising
However, jump forward six months and mounting geopolitical tensions and energy risks – amplified last week by America’s bombing of Iran – have put the world on notice that stagflation-inducing conditions are on the rise.
Even by the reckoning of the U.S. Federal Reserve (The Fed) the U.S. economy is a lot closer to the S-word - where recession and inflation effectively meet – than anyone cares to admit.
While the Fed’s chair Jerome Powell has refrained from using the S-word, anyone reading the tea leaves embedded with his recent comments can infer that this is what he meant.
Powell more or less admitted that the stagflation genie was out of the bottle when he commented that “unemployment is likely to go up as the economy experiences anaemic growth, in all likelihood, and inflation is likely to go up as tariffs find their way – and some part of those tariffs comes to be paid by the public,” he said.
Trump tariff tipping point
Admittedly, given that unemployment is still low, and economic growth has mostly been solid, the U.S. isn’t experiencing stagflation just yet.
However, there’s broad consensus that U.S. President Donald Trump’s policies are hurtling the economy towards this outcome.
Unsurprisingly, given this outlook, Trump has being pressuring Powell to lower interest rates to deflect the impact – notably higher prices and slower growth - that his tariffs have inflicted on American consumers.
But despite an incendiary blast of ridicule and name calling, Powell has so far refused to be bullied by Trump’s remarks.
In fairness to Powell, the Fed was still trying to stamp out that inflation when Trump took office.
However, the arrival of Trump into the Oval Office last January clearly compromised Powell’s playbook.
In other words, combating inflation and unemployment when they both rising is a tight rope walk between maximum employment and stable pricing.
Meanwhile, Powell has made it clear he’s in no rush to cut interest rates while there’s so much uncertainty about the direction of the economy.
The risk for Powell is that waiting too long to respond in either direction could only exacerbate excessive inflation or a recession.
Investors remain overconfident
With investors having so much to deal with in the last six months, JP Morgan CEO Jamie Dimon suspects they’ve been shell-shocked into believing that any bad news in the real economy - and any dip in equities – presents a buying opportunity.
Given that the inflationary and slower growth effects of tariffs are yet to be seen, Dimon believes the risks of stagflation are basically double what the market thinks.
Despite Wall Street analysts almost halving market-wide-earnings growth for FY25 from 12% to 7% – following March quarter earnings season – Dimon’s suspects even these revised forecasts could be ambitious based in the pending tariff hit.
In a worst case scenario Dimon warns the market that by year’s end earnings estimates could end up being dialled back to zero, with tariff uncertainty forcing companies to lower or refrain from offering guidance.
Given the present realities currently playing out right now - bond yields remaining high on the back of the U.S. debt crisis and lower earnings forecasts for corporate America – it’s easy to see why U.S. equities are looking gratuitously over-priced.
Where to from here?
Courtesy of Trump’s tariffs and broader uncertainty about his trade and economic policies, most forecasters expect to see inflation escalate while growth slows.
By their own admission, Fed officials now expect GDP to grow at just a 1.4% rate in 2025 down from the 1.7% predicted in March.
Added to growing speculation that stagflation is in the march, they expect consumer prices to rise 3% this year, significantly above their March forecast of 2.7% and unemployment to rise to 4.5%, up from 4.4% previously.
Admittedly, that doesn’t make full-blown stagflation a lay down mazaire.
However, economists unanimously believe these conditions to be “stagflationary,”.
While one economist, Joseph Brusuelas from accounting firm RSM, describes the current market conditions as “stagflation lite”, he concedes that the risks of true stagflation could be rising.
Israel’s war on Iran has led to a sharp increase in oil prices, however they remain somewhat benign relative to the quadrupling of the oil price in 1973 courtesy of the Arab oil embargo during the Yom Kippur War.
However, if the war spreads, it could lead to a more severe increase, which could send shock waves through the global economy.
Without putting too fine a point on it, the two bouts of U.S. stagflation in the mid- and late 1970s both followed oil-price spikes and had far-reaching global ramifications.
What stagflation means for equity investors
Despite fears rising that the U.S. – and the global economy - could be heading in a stagflationary direction, analysis by Duncan Lamont Head of Strategic Research at Schroders suggests that stocks often perform well [when there is stagflation], just not as well as at other times.
Lamont reminds investors that there’s been divergence in sector performance in these environments and performance between companies is likely to rise, too.
“There is an argument that the sector allocation to European stock markets could benefit them relative to the US,” said Lamont.
“As well as the well-trodden valuation argument, this is one more reason why we believe investors should be wary of passive approaches to investing in global equities today.”
However, even if the U.S. does enter stagflation, Lamont also reminds investors there’s no historical reason why they should expect stocks to fall.
“There can be lower conviction of strong returns but predicting doom is not appropriate either,” he notes.
Given that tariff shocks today are profoundly different from many stagflation experiences of the past, he said it’s problematic making sweeping conclusions about sector performance.
However, given that the U.S. stands out for its large allocation to the IT sector, it has historically struggled during stagflation, notes Lamont.
Based on past performance during stagflationary periods, Lamont’s analysis has drawn the following conclusions:
- Defensive sectors such as utilities and consumer staples perform relatively well, as demand is less sensitive to the economic cycle.
- Energy and materials companies have typically performed well because high commodity prices have often been a cause of the high inflation during stagflation.
- Consumer discretionary usually underperforms consumer staples, as individuals cut back on non-essentials.
- IT and communication services also both have a poor track record.
- Financials have performed poorly.
Dial down the hype
While fear of stagflation was the main reason central banks were so aggressive in 2022, Shane Oliver chief economist with AMP reminded the market that higher tariffs in the U.S. and higher oil prices pose a risk this time around.
He says that partly explains why the Fed is not wanting to cut rates right now despite Trump’s annoyance.
He also reminded the market that current oil rises in no way mirror what happened in the 1970s.
So far oil prices are still below average levels of last year.
“They could surge above US$100 a barrel and maybe to US$150 if Iran disrupts oil through the Strait of Hormuz and it’s a wait and see at the moment,” Oliver told Azzet.
“But that would be less than the four fold rise in oil prices in 1973 and the three fold rise in 1979 and would likely be a temporary spike in oil prices rather than a level shift higher in oil prices.”
Oliver suspects the U.S. would quickly stop Iran from disrupting oil supplies.
While there could be a boost to energy prices, he doubts it would be as lasting as the 1970s shocks.
Given that today inflation expectations are much lower, he also doubts it would flow through to a permanent rise in inflation like it did back then.
“In other words, any stagflation would likely be short lived, and if anything, it would be more of a drag on spending than boost to inflation,” he says.
“This has been pretty much the story from oil shocks since the 1970s.”
Four reasons why talk of stagflation is overblown (Source: Schroders)
- Stocks perform worse during stagflation than at other times but the difference is not statistically significant.
- Good performance in stagflation is not dependent on the market having fallen beforehand nor are rate cuts a necessary ingredient.
- Performance during stagflation varies a lot between sectors, and across historical episodes.
- There will be increased variation in performance at the company-level should the U.S. enter stagflation.