Many of us are old enough to remember the 1970s and the early and mid-1980s when interest rates spiked significantly. The 2-year U.S. treasury yield rose to 16.9% and the 10-year topped out at 15.8% in September of 1981. The cause of this was “stagflation,” or persistent high inflation combined with stagnant GDP growth.
With the recent spike in the Consumer Price Index (CPI), a widely-used measure of inflation, investors are beginning to wonder if we could be headed for another period of stagflation. The CPI rose 5.4% year-over-year in July, its highest reading since July 2008 when it was 5.6%. This, combined with expectations of lower growth due to reduced stimulus and supply chain constraints, has investors talking more about stagflation. Since 1970, year-over-year CPI has averaged 3.9%, but since 1990 it has averaged just 2.4%.
CPI vs. Yields
In 2020, the Federal Reserve changed its stance on managing inflation. They had previously maintained a 2% inflation target whereby they would raise or lower short term interest rates to try to keep inflation steady. Now, the Fed has elected to adopt a “flexible form of average inflation targeting” that aims for the inflation target to average 2% over time. This change will allow the Fed to let inflation run hot, or above 2%, for a period without having to raise interest rates quickly to try to bring inflation back down. The risk to this new strategy is if inflation runs hot for too long, it would potentially be even more difficult to get back under control.
Stagflation puts the Federal Reserve in a difficult situation. On one hand, high inflation should lead the Fed to raise interest rates to subdue the uptick in prices. On the other hand, with slower growth the Fed would want to lower interest rates to promote growth. Not only is the Fed in a difficult situation, but investors are too.
Investing during periods of stagflation can be difficult. With rising interest rates, bond returns will likely be muted, especially when starting from the extremely low rates we have today. Comparing the bond market of today versus the bond market of the 1970s and 1980s can be difficult. Interest rates were significantly higher during the 1970s, which means coupons (interest payments) were multiple times higher than they are today. Secondly, the average duration (a measure of the sensitivity of the price of a bond to a change in interest rates) of outstanding bonds was significantly lower than it is today. That means that during the 1970s and 1980s, rising long-term interest rates had less of an impact on the total bond market than they are likely to have today.
During periods of rising inflation, equities and commodities may provide higher returns. Rising interest rates generally mean the economy is expanding. However, in stagflation the economy is stagnant or seeing low growth. More defensive sectors such as health care, agricultural goods (food) and commodity-related industries tend to perform well during periods of stagflation.
Historical Market Returns
Ancora’s Fixed Income team continues to monitor economic conditions and we believe that the Federal Reserve will do everything it can to prevent stagflation from creeping into the economy. However, we acknowledge that as inflation continues to run hot, it becomes more and more difficult for the Fed to retain control of it. We are keeping a close eye on wage inflation as well, as we believe this could be the catalyst that leads to even higher inflation than we are already seeing. Maintaining a well-diversified portfolio with exposure to multiple asset classes, potentially including commodities and dividend-paying equities that consistently grow their dividends, could allow investors to better weather times of increased inflation.