Zacks Investment Management

There is an ongoing debate in the financial world over whether the U.S. economy is headed for—or already experiencing—a period of stagflation. The ongoing war in Ukraine has only added to these fears. For readers who may not be familiar with the term, stagflation refers to an economic condition characterized by high inflation and falling and/or weak growth, sometimes with the accompaniment of high unemployment.

It should come as no surprise that stagflation is a material negative for equity markets. During quarters when the U.S. economy posted stagflation-like numbers, the S&P 500 has fallen a median -2.1%. That’s compared to the index’s median +2.5% quarterly increase when stagflation wasn’t present.¹

The last instance when the U.S. economy endured stagflation was in the late 1960s and 1970s, which was also a time characterized by rising oil prices. Given tight oil supplies in the current environment coupled with the risks to energy markets tied to the war in Ukraine, some fear that the risk of stagflation in the U.S. and around the world is rising – and we could be headed for an outcome similar to the 1970s. Some readers may remember the S&P 500 experiencing a long and grinding bear market in 1973-1974.

Fortunately, comparisons to the 1970s do not have much merit, in my view. Inflation during the 1970s was roughly double what it is today, and the Fed ultimately raised interest rates to nearly 20% by 1980. Present-day, inflationary pressures are showing early signs of easing (more on that below), and the Fed has plans to raise the fed funds rate to about 2% by the end of the year, which is a far cry from where policy landed back in 1980. The 1970s also featured government price controls that constricted energy supply, which does not apply today.

That all being said, I do think it is worth examining whether stagflation risks are on the rise, which means taking a closer look at growth, employment, and inflation trends in the U.S.

I’ll start with growth. If the U.S. economy is on the verge of entering a slow patch, it is not yet evidenced in fundamental data. Leading economic indicators, as measured in the Conference Board’s Leading Economic Index (LEI), increased by 0.3% in February to 119.9. For scale, the LEI was at 100 in 2016, when the U.S. economy was firmly in growth mode. The U.S. economy has never entered a recession when LEI is high and rising, as it is now.²

Another key metric to look for when measuring economic activity is the U.S. Services PMI, given the U.S. is a service and consumption-based economy. In February, activity in the U.S. services sector grew for the 21^st month in a row, registering at 56.5%. Any reading above 50 is expansionary, which again confirms the U.S. is currently in growth mode.

Finally, I think it’s important to look at the yield curve for clues as to whether growth conditions are present. A steepening yield curve is what investors should look for – it indicates that banks’ net interest margins are rising, which generally incentivizes loan growth and portends economic growth. A glance at the yield curve today – measured as the 10-year U.S. Treasury bond yield minus the 3-month Treasury bond yield – shows the curve is steepening, a good sign.

Source: Federal Reserve Bank of St. Louis³

On the employment front, nonfarm employment jumped by 678,000 in February, which was well above economists’ forecasts. November and December jobs numbers were also revised higher to 92,000, underscoring the modest impact the Omicron variant had on the U.S. labor market. At last measure, the U.S. unemployment rate sits at 3.8%, which marks a continued decline over the last several months even as the labor force participation rate has moved slightly higher. In the chart below, initial jobless claims – a proxy for layoffs – have steadied at close to pre-pandemic levels. Put simply, I do not see any stagflation signs in the labor market.

Source: Federal Reserve Bank of St. Louis⁴

Finally, there’s the inflation factor. In my view, there are two parts to the inflation story. The first is pandemic-induced inflation, which saw consumers shift purchases to goods versus services at a time when restrictions, factory closures, and labor shortages led to numerous kinks in global supply chains. Signs are emerging that these inflationary pressures are easing – shipping bottlenecks and supplier delivery times are falling, and the long lines of container ships at the U.S.’s biggest ports are shortening. I also think U.S. consumers are poised to shift spending back to services, which could ease pressures further.

The second part of the inflation story is what we are seeing now with higher commodity prices tied to the war, and also with workers exerting some leverage over wages. These two forces I believe could keep the U.S. in a longer period of elevated inflation, but not the dangerous kind – perhaps more in the 3% to 4% range, versus the desired 2%. Though the 10-year breakeven inflation rate is rising as seen in the chart below, it is still just at 3% – again, not necessarily a dangerous level for inflation.

Source: Federal Reserve Bank of St. Louis⁵

Bottom Line for Investors

Inflation is present in the U.S. economy, and while some pressures are likely to ease as consumers shift spending to services and global supply chains normalize, the war in Ukraine could fuel a longer cycle of high commodity prices. This could cause inflation to settle at a rate higher than the target ~2%, which is what is causing many to raise stagflation worries.

But sustained inflation above 2% does not automatically imply stagflation – the U.S. economy remains on strong fundamental footing, jobs are plentiful, and I see plenty of growth ahead in 2022. The stock market can absorb slightly higher inflation if growth and earnings remain solid, which is what I see this year.

DISCLOSURE