Stagflation is the next risk investors need to worry about

A recession is becoming the base case for the economy. The worst-case? Stagflation. Investors, hold on to your handrails as we go back in time.

You ain’t seen nothing yet

Low and stable inflation is a sign of a healthy economy, with most central banks targeting a 1-2% inflation rate. What we have right now in the U.S. — 8.3% for the 12 months ending April — is not healthy.

Asking the hard question: What happens when growth slows, and inflation remains high? We get stagflation — considered the central bank’s worst nightmare.

But there’s no set way to measure whether we’re in stagflation. Some argue that we’re already in a period of stagflation — while Economist Mohamed El-Erian thinks a brief period of stagflation is unavoidable (BBG).

• Per a Bank of America fund manager survey, stagflation expectations rose to 66% — the highest since 2008 (BBG).
• Europe — which has greater exposure to the war — could be at a higher risk of stagflation.

To get an idea of how bad stagflation can get, let’s go back in time…

The 1970s all over again?

Economists are seeing similarities in today’s economic conditions and the 1970s — the last period of stagflation — known for high inflation and unemployment rates.

• The U.S. unemployment rate jumped from 4.8% in 1973 to 9% in 1975.
• Western nations had a major oil shortage causing oil prices to surge nearly 5x between 1973 and 1980.

To combat high inflation (12.3% in 1974) — the Fed raised rates from 3% in 1972 to over 12% within two years. This led to two of the worst years for the S&P 500 — down 17% in 1973 and nearly 30% in 1974.

The historical silver lining: The S&P 500 returned 32% and 19% in the following two years.

Investors: When should we start worrying?

Per the Chief Investment Strategist of Leuthold Jim Paulsen (Barron’s), investors should worry when companies cut jobs, leading to higher unemployment — as seen in the 70s. Three key indicators to watch:

1/ Employment: Major tech firms have begun laying off employees — but unemployment was still at a low 3.6% in April and hasn’t spread to other industries.

2/ Retail sales: April’s high-level retail sales data remained strong — but many retailers are already feeling the pressure from inflation.

3/ Inflation:

The Fed is raising rates to fight inflation — but if inflation doesn’t fall, stagflation could follow.