Threat of stagflation rears its head

High inflation, low growth. Sound familiar? The spectre of 1970s-style “stagflation”, banished for decades, has crept back into investors’ consciousness.

Oil prices may have tumbled from recent highs, but crude remains well above $100 a barrel. Sharp rises in the price of food staples are already causing pain in many of the world’s emerging economies. Now, central banks in the US and UK have downgraded their growth forecasts and raised those for inflation.

With recovery still fragile in the US and many parts of Europe, there are fears rapidly increasing prices for fuel and food could begin to push up prices of other goods and services more quickly. Such a scenario, combined with weak growth, could lead to stagflation reminiscent of the seventies.

“Stagflation is the biggest risk for the markets,” says Robert McAdie, global head of credit research and strategy at BNP Paribas. “Inflation is real and here to stay. It is a serious issue especially if growth remains weak. If this leads into stagflation, then all bets are off for the markets and the global economy.”

Jeremy Grantham, founder and chief strategist of GMO, the US fund manager, worries that the fall in prices of most commodities that provided a benign backdrop for growth in the 1990s and early part of the last decade will not be repeated.

“From now on, price pressure and shortages of resources will be a permanent feature of our lives. This will increasingly slow down the growth rate of the developed and developing world and put a severe burden on poor countries,” he says.

Forecasts for growth and inflation in the UK are striking. In the six months to the end of March, output was flat. The consumer price index measure of inflation hit 4 per cent in April, well above the Bank of England’s targeted 2 per cent rate, while retail price inflation was 5.3 per cent. This week the Bank cut its growth forecast for this year, to 2.75 per cent from 3.1 per cent, and estimated that CPI inflation could reach 5 per cent.

The Fed recently increased its forecast for US inflation to 2.1-2.8 per cent for this year and cut growth expectations to 3.1-3.3 per cent. Yesterday’s official data showed US consumer prices rose 3.2 per cent, the highest since October 2008.

Suki Mann, credit strategist at Société Générale, doubts that stagflation on the scale of the 1970s, when annual inflation rates in some developed economies, such as the UK, rose above 20 per cent, will return. But he warns of the risk of so-called “stagflation-lite”, where inflation runs at 5-10 per cent and growth stagnates.

“A sharp rise in inflation is bad news for everyone. There is a risk of this because of weak growth and inflationary pressures from food and commodity prices,” he says.

But Jim O’Neill, the bullish head of Goldman Sachs Asset Management, says: “I don’t believe in stagflation. I think the big story in the second half of the year will be slowing inflation and some easing in commodity prices.”

The retreat in commodities prices over the past 10 days lends some support to his thinking, while stronger-than-expected eurozone growth numbers on Friday, boosted by Germany, show that some economies are well on their way to recovery.

Kenneth Rogoff, former chief economist of the International Monetary Fund and now a professor at Harvard University, says slow growth is par for the course after a deep financial crisis. Given the low growth, he says, inflation above central banks’ targets could be helpful: “A bit of inflation is by far the lesser evil compared with even lower growth. Five per cent inflation for 2 to 3 years is not the end of the world. There are even some benefits.”

These benefits relate to the levels of debt in the west, a problem he calls “utterly profound”. Inflation may help with “deleveraging”, or cutting debt, as it reduces the sum to be paid back. Mr Rogoff contrasts today’s situation with four decades ago: “In the 1970s the inflation was aggravating the growth problem. Here inflation is helping ease the problem of deleveraging.”

So far equity markets are shrugging off concerns about growth. The S&P 500 is down 1 per cent from its post-crisis peak at the end of April. But bond markets have reacted differently, with US Treasury benchmark yields falling, a slide many attribute to weakening growth prospects.

Strategists say one simple way to hedge against stagflation is to bet that inflation will rise sharply by trading inflation swaps while at the same time betting equity markets will fall, using equity futures, due to stagnating growth.

Gibson Smith, co-chief investment officer of Janus Capital, points out that, over the past 200 years, stagflation “is not a common outcome”. But he expects core inflation to almost double in the next year to more than 2 per cent, meaning that “it will get a lot of attention in markets in six months”.

His biggest worry is that the near-universal expectations that yields will rise over the rest of the year turn out to be misplaced. “The downside risk of being wrong if rates stay contained is high ... My concern is that when the consensus is so focused on one outcome and with high conviction, then the outcome becomes less likely.”