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Market Extra: Here’s the threat to markets if investors ignore ‘nontrivial’ stagflation risk

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Financial market participants completely missed the non-transitory nature of inflation over the past year, failing in what one portfolio manager describes as “spectacular fashion.”

Now, as investors and traders worry about the prospects of a U.S. or global recession, they’re staying attuned to profit warnings like the one from Walmart Inc., which demonstrate that inflation is taking its toll. But they have yet to reach a full consensus view about stagflation, or the unwelcome combination of slowing growth and high inflation considered by many to be the worst of all possible outcomes.

“We worry that the market is not adequately considering the tail risk that inflation continues to surprise to the upside even as growth slows,” said Maneesh Deshpande, managing director and head of U.S. equity strategy and global equity derivatives strategy for Barclays. “It is not our baseline scenario, but there is a non-trivial probability that we enter into a 70 style stagflation scenario,” Deshpande told MarketWatch by email.

For now, markets are largely trading on the view that an impending U.S. recession will help bring inflation down eventually and may even curtail the Federal Reserve’s aggressive rate-hike campaign. The so-called peak inflation trade, or idea that inflation has run its course and is poised to taper off, is what is largely driving markets of late: Long-term break-even rates have leveled off in recent days, while yields on Treasury inflation-protected securities are flat since Monday after a few days of declines, according to Tradeweb data.

Gavin Stephens, director of portfolio management at Goelzer Investment Management, said that “we’re currently in a state of stagflation, and the market doesn’t seem to appreciate that the Fed will not tolerate it.”

“Whether it’s declining market-based inflation expectations or increasing confidence in the Fed making an early 2023 dovish pivot, markets seem to have embraced some wishful thinking on how the Fed will react to recent inflation data,” Stephens wrote by email.

Key Words: Here’s what Bill Ackman says Powell should tell traders about Fed rate-hike plans

Much is riding on the view reflected in financial markets that a falloff in economic growth should equal a falloff in inflation. Incoming data shows that corners of the U.S. economy are deteriorating rapidly, and the International Monetary Fund is warning that the global economy faces the possibility of a severe downturn. But inflation has shown a propensity to surprise toward the upside, and there’s a risk that falling oil and commodity prices could be offset to some degree by rising prices in other categories like shelter, some say.

Investors and traders are “not really talking about stagflation as an economic reality, though that conversation is starting to pick up,” said James Camp, managing director of strategic income at Eagle Asset Management in St. Petersburg, Fla. “The honest truth of all this is that few practitioners in the financial market have even dealt with inflation, and a regime change to inflation is what we are living through right now. That’s the seismic shift we’ve had to digest in the first half of this year.”

“Shelter costs are underappreciated and rents are punishing to the average American,” Camp said via phone. “Consumer wages are not going up. Consumer savings is falling, and consumer credit is increasing. The main wild card is the labor market. If the labor market cracks, no question about it, the consumer will follow.”

Overall, “it’s wishful thinking to say that inflation will go into the rearview mirror. There are too many frictions in the economy,” and commodities such as oil are “likely to turn higher into the back half of the year,”Camp said. He expects annual headline CPI inflation rate to stay above 6% through year-end, versus its June level of 9.1%, and to hit stocks even further.

Eagle Asset Management, which manages $32 billion, is an affiliate of Carillon Tower Advisers, the asset management arm of Raymond James. The strategic income portfolio which Camp manages had been composed of 60% in risk assets at the end of last year, but has since dropped that allocation down to 40%. Eagle Asset is also “constructive on Treasurys, but thinks there’s another leg down for corporate spreads and equities,” Camp said.

Ahead of the Fed’s rate decision on Wednesday, financial markets appeared to reflect a mostly recession, not stagflation, trade: All three major U.S. stock indexes
DJIA,
-0.71%

COMP,
-1.87%

SPX,
-1.15%

were lower in afternoon trading. Meanwhile, Treasury yields were mixed, with the 10-year rate
TMUBMUSD10Y,
2.805%

below 2.79%.

Jack McIntyre, a portfolio manager at Brandywine Global, said he doesn’t think market participants are underestimating the likelihood of stagflation. He adds that recent price action in equities and bonds more or less acknowledges this risk.

Concerns about lingering inflation against the backdrop of slowing economic growth “is likely a key driver of recent selling we’ve seen across various asset classes (both bonds and equities – cash has been only place to hide out),” McIntyre wrote in an email.

A true stagflation trade would be “moving to cash because both stocks and bonds are experiencing weaker performance,” McIntyre said. However, “stagflation isn’t sustainable if the Fed sticks to its primary mandate of breaking inflation,” though “we may have to break the economy to break inflation.”

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