Stagflation scenario

Market Comment, November 2022

Stagflation scenario

Unprecedented stimulation of the global and, in particular, the US economy is likely the chief cause of increasing stagflation risks. While this stimulation was justified in 2020, this was no longer the case in 2021, as indicated by equity prices at the time. Both US President Trump and US President Biden sent cheques to Americans, thereby creating a surplus of demand relative to supply in the economy. A further decisive factor was that the US Federal Reserve kept interest rates low for too long. This led to too much monetary liquidity and rising valuations, which are steadily adjusted following an upwards exaggeration.

This year, it has really become increasingly clear to everyone how the US Federal Reserve has failed to keep pace with the inflation trend. It should have started much earlier with its marked interest rate hikes and already got the ball rolling last year. When US President Joe Biden once again fired up the US economy in the first quarter of 2021 by sending cheques to the American people, the economy was in fact already too strong in terms of growth after having previously received unprecedented support from the US Congress in 2020. Nevertheless, the US Federal Reserve continued its bond purchases at a level never seen before, thus artificially keeping US interest rates much too low for too long. 

Arguing that inflation (which was already visibly rising) was only temporarily higher, the US Federal Reserve continued to purchase enormous volumes of bonds. Mortgage-backed bonds were still being purchased as late as winter 2021/2022, providing the housing market with unnecessary support despite the fact that US house prices had already risen by 20%! If this cannot be put down as a monetary policy mistake, then there have been very few cases that can...

Insights into the current situation can be found by looking for parallels in economic history. During the 1970s, so-called stagflation arose in a similar environment. This term denotes a scenario in which there is a steady, at first hardly noticeable, but then more pronounced weakening of the economy that goes hand in hand with above-average inflation. Generally speaking, the consensus among economists in the 1970s was that unemployment could be kept low if higher inflation was tolerated. The US Federal Reserve adopted a similar line of argument last year with its new target of higher “average inflation”. Around 1970, however, the economist Milton Friedman had already explained that inflation is invariably a monetary phenomenon. In other words, it is caused by “too much” monetary stimulation and too low interest rates together with excessive monetary liquidity. Finally, during the 1980s, the then US Federal Reserve Chairman Paul Volker had to implement an extreme hike in interest rates because his predecessor had kept them too low for too long (for political opportunistic reasons to support the Nixon administration).

The price increases are especially impacting those with lower incomes, not only in the US.

Gérard Piasko, Chief Investment Officer

In a similar vein, current Fed Chair Jerome Powell’s overly loose monetary policy helped finance the US government’s deficits, which resulted from inappropriately high levels of economic stimulus. Biden wanted to secure his election as US President at the end of 2020 by promising to send out more cheques to the US population. After becoming the new occupant of the White House, there was then once again an excessive flood of dollar bills. It therefore comes as little surprise that excessively high demand on the part of American consumers combined with overly cheap money and too low interest rates has now led to a historic spike in inflation. To quote Goethe’s Sorcerer’s Apprentice, “the spirits that I summoned up I now can’t rid myself of”, and this very much also applies to the economy.

We are now seeing how the price increases in the US and worldwide are particularly hitting those with lower incomes who have to spend a high percentage of their earnings on food, rent, petrol and oil. History has shown, however, that it is difficult to reduce high inflation like we are now observing in the Eurozone and US without simultaneously risking a sharp economic slowdown. Stagflation risks have therefore increased significantly. 

This situation has several implications. Everything that has benefited from the very long period of extremely low interest rates and increased massively in price over the years is in the process of adjusting its valuation. The high valuation of growth stocks relatively to values stocks, which remain less expensive by historical standards, are one example, while the housing markets in many countries, which have become more expensive, are another. It is in the hands of the US Federal Reserve, in particular, and the European Central Bank not to make any more monetary policy mistakes after the ones seen in the past year. Stagflation risks have to be reduced. In the meantime, caution is the order of the day, even during temporary recoveries on the capital markets. We are continuing to focus on quality in both the equity and bond spaces. Stable margins, relatively low debt and pricing power are some of the qualities that we are looking for in these difficult times of rising interest rates.

Gérard Piasko

Gérard Piasko

Gérard Piasko is Chief Investment Officer and head of the investment committee of private bank Maerki Baumann. Before he was for many years Chief Investment Officer of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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Editorial deadline: 7 November 2022

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