The "soft landing" dream scenario for stocks is a mild economic downturn with inflation pressures that gently melt away toward zero.
In this scenario, the Federal Reserve cuts interest rates multiple times to avoid a recession.
The economy then muddles through with no major accidents, and a combination of falling inflation and falling interest rates gives a further sentiment boost to stocks.
The opposite of the dream scenario — call it the nightmare scenario — is one in which economic growth deteriorates and inflation persists or even accelerates, causing interest rates to go higher.
In the nightmare scenario, corporate earnings take a hit as consumer spending dries up because the economy is stalling out.
At the same time, valuation multiples take a hit as interest rates, which normally fall in economic downturns, stay elevated or even rise because of persistent or accelerating inflation pressures.
This nightmare scenario is known as "stagflation."
Stagflation is a portmanteau (a word made by combining other words) of "stagnation" and "inflation" put together.
Stagflation as a concept is mostly associated with the 1970s and was first coined by a British politician named Iain Macleod in a speech to the British House of Commons in 1965.
Stock markets tend to get hammered in periods of stagflation because inflation destroys purchasing power even as interest rates move the wrong way, which puts pressure on equity valuations.
Let us say, for example, an S&P 500 stock is trading at a price-to-earnings multiple of 25 heading into a stagflation period.
If earnings decline by 25% (because of reduced consumer spending) and the price-to-earnings multiple compresses by 25% (because of interest rates and inflation), the stock price falls by almost 44%.
Then, too, an environment of rising interest rates hits profit margins directly through higher financing costs... while a backdrop of inflation means higher material costs... and higher interest rates destroy the economic value of share buybacks with borrowed funds (a factor that buoyed stocks all throughout the 2010s).
We bring this up because, last week, the prospect of stagflation came back into the conversation.
Even as quarterly U.S. GDP data came in lower than expected, a measure of inflation known as Core PCE showed signs of picking up.
The "PCE" stands for personal consumption expenditures, and "core" means excluding volatile items like food and energy.
Core PCE is a preferred inflation measure of the Federal Reserve, meaning the Federal Open Market Committee pays close attention to this measure in deciding whether or not to cut interest rates (or hold them or raise them as need be).
The gist of the problem is that, if inflation stays sticky, the Federal Reserve can't deliver the interest rate cuts that Wall Street wants. Worse still, if inflation accelerates, the Fed may even have to raise rates again.
Another thing to watch is the trajectory of the U.S. Treasury 10-year yield (the most important interest rate in the world).
The 10-year yield has been creeping higher for months. At the current pace, it could be challenging the 5.0% level by summer, which would mean higher mortgage rates and greater pressure on the semi-frozen housing market.
Other economies are experiencing pressures too. Japan, for example, is wrestling with a currency crisis as the Japanese yen hits multi-decade lows, and Europe on the whole is in danger of following Germany into a recession.
When the FOMC announces the latest policy decision on Wednesday of this week, it is highly likely they leave rates unchanged (no cuts or hikes).
Investors will be listening closely to the after-meeting press conference, though, to try and get a sense of how much the recent inflation numbers have influenced Fed Chair Jerome Powell's thinking — and the degree to which he is worried about stagflation.
Until next time,
Justice Clark Litle Chief Research Officer, TradeSmith
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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