Stagflation Risk Remains, The Fed’s Forecasts Confirms It
key points:
- Stagflation Risks Are Rising: Increasing inflation and slowing GDP growth suggest economic challenges ahead, particularly for equity markets.
- The Fed’s Forecasts Confirm the trend. In its latest FOMC meeting, the Fed boardmember’s poll showed a deterioration of GDP growth and inflation expectations, confirming a trend that started in December.
- Investors Should Stay Defensive: The Fed’s reaction to stagflation would likely be a recessionary tightening of monetary policy, which would particularly hurt prices of mega-cap tech stocks underpinned by fast growth. Investors could dilute exposure to stagflation risk by increasing cash allocation and pivoting to dividend-paying sectors.
What did the Fed say?
The Fed confirmed a clear inflection-to-negative in both inflation and growth trends, which began in December and accelerated in March. The Fed polls attendants to its Federal Open-Market Committee (FOMC) policy meeting to gather economic forecasts for 2025 and beyond. Between mid-2023 and Sep 2024, the poll was remarkably stable, with the median for 2025 GDP growth at 1.8%-2.0% and PCE inflation at 2.1%-2.3%. But in December the inflation forecast median moved up to 2.5% (GDP growth clocked at 2.1%) and in March the trend accelerated to a 2.7% PCE inflation forecast, while GDP growth clocked a marked slowdown to 1.7%.
The convergence of two negative trends in inflation and GDP growth is not normal, and adds to the sense that stagflation risk is increasing. Normally, the economic cycle moves between an overheated economy with high economic growth and accelerated inflation, and a cooling economy with low growth and low inflation. The chunk in the middle is usually seen as a “goldilocks scenario,” with both comfortable inflation (the Fed targets 2.0%) and GDP expanding at a reasonable pace (probably between 2.0% and 2.5%). However, stagflation puts both variables in negative territory - GDP growth slowing and prices rising faster - and the latest forecasts provided by the Fed contribute to the data signaling that the risk of stagflation keeps growing.
Again, Stagflation is a Different Animal - And The Market Seems Sanguine
Stagflation blunts the Fed’s tolls, turning scalpels into mallets. The Fed’s conventional policy toolbox allows it to pull the economy from each economic cycle extreme - whether over-heated or over-cooled - towards the “goldilocks scenario,” with little disruption by tightening or relaxing monetary policy in small increments. However, in stagflation that give-and-take between growth and inflation doesn’t work, forcing the Fed to stagger its response: it will initially forcefully attack inflation deepening the economic slowdown - even causing a recession - with strict tightening. Only after inflation is under control would the Fed turn its policy focus into stimulating the economy.
We’ve seen this one before (albeit a while ago). In 1979-1983 the Fed’s chairman Paul Volcker hiked rates to over 20% to control double-digit inflation. The policy allowed the Fed to cut inflation to 3% by the end of 1983, but it also caused back-to-back recessions in 1980 and 1983 and near 11% unemployment in 1982.
Cautious Until Summer, and Wait and See What Happens Next
Despite a still-low chance scenario, a combination of declining earnings and higher rates would be a strong headwind for equities. The most tracked equity indices - S&P500 and Nasdaq100 - have over-concentrated around a dozen high-growth, tech-centric names. These names typically trade at 30x+ P/E multiples based on their higher-than-historically normal growth rates and moderate discount rates for their terminal values. These stock price underpinnings are the most vulnerable to a combination of slower GDP expansion, which drags earnings growth, and fast price inflation, which keeps discount rates high.
To mitigate the exposure to the risk of stagflation, investors should consider increasing the allocation to cash, or rotate their equity allocation to defensive sectors with high dividend distributions.
