With Stagflation, Investors Damned If They Do, Damned If They Don’t

Stagflation looms.

That’s the zeitgeist across markets, and it’s visible pretty much everywhere you care to look. Breakevens are near record highs and traders are betting the Fed will be forced to pivot and cut rates in 2024, a vote of no confidence in the “soft landing” narrative.

The odds of inflation falling back near target in the near-term are very low and although you might still describe longer-term expectations as “anchored,” they’ve risen too. “Markets have further repriced risk of stagflation, boosted by the commodities rally due to the Russia/Ukraine crisis,” Goldman’s Christian Mueller-Glissmann wrote, in a new note. He flagged the widening gap between breakevens and real rates (figure below).

“This points to little optimism on long-term real growth and material concerns on inflation risk,” Goldman said.

That doesn’t bode well for balanced portfolios. Earlier this week, in “It’s Broken,” I rekindled the 60/40 drawdown discussion in light of what, so far anyway, is shaping up to be the worst annual stretch since the financial crisis for a strategy that came to be viewed as the bedrock of prudent asset management.

Although I doubt this is news to most readers, it’s nevertheless worth mentioning that if we’re in for a repeat of America’s last major bout with stagflation, returns for 60/40 portfolios could be “very poor” in real terms, as Goldman put it. The figure (below) is instructive.

It’s important to note that the ramifications of this go beyond the obvious. Plainly, the lower yields are and the more persistent inflation turns out to be, the less useful bonds are as a hedge. So, you’re better off tilting towards equities.

But that’s potentially perilous during periods of high uncertainty and elevated volatility — you’re trading one risk (the risk associated with owning overvalued bonds in a high-inflation environment) for another (increasing your allocation to risk assets).

The figure (below, from Goldman) shows the odds of suffering negative real returns in stocks diminish dramatically with longer holding periods, which, again, argues for piling into stocks if you expect inflation to linger.

The odds of losing money (in real terms) in bonds and cash remains about the same across horizons.

But, as noted, stocks are risk assets. And being overweight risk assets is chancy during economic turbulence. So, when stagflation comes calling, investors are left staring at a “damned-if-you-do, damned-if-you-don’t” situation.

“Higher equity allocations increase portfolio risk and the potential for large drawdowns in the near-term, especially in the event of recessions,” Mueller-Glissmann wrote. “But with equities the risk of poor real returns declines with the investment horizon,” while “the risk of losing value in real terms over the long run with cash and bonds is higher.”

There’s nothing especially profound about any of this, but it’s worth reiterating. As Mueller-Glissmann put it, “in order to reduce the risk of poor real returns in the medium-term investors might have to accept more risk in the near-term.”