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Stagflation is Coming

With consumer prices soaring to levels not seen since the early 1980s, many pundits are predicting the economy will enter a period of stagflation that could persist for years. Stagflation is any period marked by both rising inflation and rising unemployment, something our economy has not experienced since 1980. Despite the infrequency of periods of stagflation, investors have started taking precautionary measures.

Investors, professionals, and speculators have bought into the stagflation narrative in a big way. Under the belief that higher consumer prices will ultimately lead to higher interest rates, investors are fleeing from the government bond market at a rate unlike any time in modern history.

In what seems like a sure bet on lower bond prices, investors and money managers continue to unload their positions without any regard to price, while speculators are shorting the bond market by borrowing bonds and selling them on the open market. To keep pace with rising inflation through a period of stagflation, investors and money managers are overweighting into stocks as they believe stocks are a superior hedge against inflation.

Investors looking back to the 1970s for cues on how to invest may find themselves on the wrong side of the trade. Without any instance of stagflation in the past forty years, investors are making a big bet that we are about to enter a period of stagflation. Investors are hoping for stocks and interest rates will continue to rise when the opposite is more likely to happen.

Before the 1980s there was a relationship between initial unemployment claims and the Consumer Price Index. The Consumer Price Index lead initial claims higher three times between the 1970s and early 1980s. Each of these three periods marked periods of stagflation which is consistent with rising consumer prices and unemployment.

Since then, the opposite has mostly happened where consumer prices fell during periods of rising unemployment. During the 1981-1982 recession, consumer prices fell as initial claims rose. Consumer prices briefly rose as the economy entered a recession in the mid-1990s before consumer prices nosedived against rising unemployment claims.

When the dot-com bubble burst and sent the economy into a recession in 2001, consumer prices crashed while initial unemployment claims rose. Going into the Great Financial Crisis in 2007, consumer prices rose for about a year before crashing into a deflationary spiral. At the same time consumer prices were crashing, initial unemployment claims continued higher.

Yet, this time, investors seem completely convinced inflation is persistent and will only head higher. With initial unemployment claims near historically low levels, it seems all too obvious initial claims will follow consumer prices higher. This belief is especially true when excluding the prior three recessions, but if recent history is a guide, rising unemployment is more likely to be met by slowing consumer price inflation.

Rather than fixate on the three periods of stagflation during the 1970s into the early 1980s, investors would be better served in trying to figure out what changed with the 1981-1982 recession where periods of stagflation have been brief. Since the early 1980s, something about the global monetary system or financial system has changed to the point where unemployment claims no longer follow consumer prices higher.

As the economy reopened from the pandemic, consumer prices shot higher while initial unemployment claims fell to one of their lowest levels in history. Using the post-1981-1982 recession as a guide, initial employment claims are soon to rise as consumer price inflation peaks.

The first, and most important change was global trade. After decades of the U.S. dollar being the global reserve currency, the world finally figured out how to use it to create global prosperity. When consumer prices rise in the U.S., low-cost foreign producers are financially incentivized to export to the United States.

Unlike the periods of stagflation in the 1970s where foreign-produced goods and services were inferior to domestically produced goods and services, foreign-produced goods and services are on par with or are superior to domestically produced goods and services. During periods of high inflation, low-cost foreign-produced goods surge into the U.S. which helps temper rising consumer prices.

As far as demand goes, the reason unemployment claims rise during periods of rising inflation is that wage growth lags behind the rapid rise in consumer price growth. With less discretionary money, consumers have no choice but to cut back on their expenditures. As spending recedes, employers no longer need as many employees as they look to cut expenses as inventory levels continue to rise.

While investors are betting big on a long period of stagflation and rising interest rates, they are about to find themselves mispositioned once again. Long-term Treasury yields are a function of growth and inflation expectations, and during periods of rising unemployment claims and slowing consumer price growth, both growth and inflation expectations decline along with Treasury yields.

This is why each of the three recessions since the early 1980s has seen a decline in Treasury yields. While there may be a brief period of stagflation, it will soon be followed by a period of deflation primarily due to an increase in imports and a decrease in consumer demand.