Stagflation And Market Crash – What to expect

This could get ugly.  Inflation numbers just came in and they are still heading higher for headline numbers.  On this news, the stock market sold off 5%.  Meanwhile, the World Bank has issued an assessment where they are predicting a period of stagflation throughout the world economies.  Stagflation, stagnant economic growth during a period of high rates of inflation are a dangerous combination because they require more than a pound of flesh should things get out of hand.  I wanted to define stagflation and then bring that into context as to what to expect for your investment portfolio.

First, the word itself is an amalgamation: the smashing together of the two words stagnant and inflation.  Stagnant growth would normally be accompanied by high levels of liquidity and policy accommodation.  The Federal Reserve would likely step in and lower interest rates to stimulate growth.

However, when you factor in excessive levels of inflation, this makes things difficult for the Federal Reserve to justify high amounts of policy accommodation.

In the meantime, the only other period of time in our nation’s history when we had stagflation – the 1970s & 1980s – there were supply shocks that roiled the supply chain initiating a drive of consumers to consume too much.

It’s different this time

While the previous period was driven by geopolitical events with oil at the root of the issue, the current situation begins with the collapse of the entire world supply chain due to COVID pandemic-driven shut down.

Outside of the fact that the initial event was the shutdown of the big chunks of the supply chain, the theme is pretty much the same: There was a shutdown of supplies and too many consumers tried to consume too much.

Let me introduce you to an economic term: Demand Pull Inflation

Stagflation & Demand Pull Inflation

Demand Pull Inflation is basically too many dollars chasing too few supplies.  I have talked about demand pull inflation previously in other articles.  But, it is becoming more prevalent and more of a problem so, I figure I better chime in a bit more; I will keep this brief.

The world worked on an on-demand supply chain system where retailers would order what they needed from suppliers who were distributed supplies from producers.  Since these suppliers had many retailers they worked with they were familiar with a consistent flow of orders & goods.

When retailers began running out of goods they would contact suppliers who would get producers to produce what was needed using whatever raw materials were necessary to produce these products.  Under normal economic conditions, this flow would be continuous and neither retailers, suppliers, nor manufacturers would stock anything more than what they may need at any time to fulfill their orders.

But, this efficient system was shattered when COVID shut down links throughout the process.  Basic raw materials become slightly more scarce.  Production levels would drop somewhat in response to lower labor availability and a broken distribution system.  The end result would be price increases as retailers and suppliers competed for their respective product needs.

Enter: More dollars

The stimulus checks were awesome for all those that received them. But, this introduced an enormous amount of money that otherwise would not have existed.  And, what did Americans do with said stimulus money that they otherwise would never have received?  They spent that money on goods they would not have otherwise been able to afford in their normal lives.

This created a surge in demand for goods across the board which, this exasperated the supply chain.  Costs increased and price increases followed thereafter.

This is demand pull inflation.

World Economic Growth

The World Bank believes that global economies are going to see continued low, and falling economic growth with high levels of inflation.  Hence, stagflation.

The big thing to keep in mind is that the World Bank assessment is for the world growth rates & inflation levels; not only the United States.  However, neither the United States operates in a contained environment, nor does the rest of the world operate without the United States or, any of the other developed nations.

But, the developing world economies have not been able to move out of their respective recessions.  While these economies have remained soft, there is the food shortage that is affecting the world’s poorest nations from the war in Ukraine.

Combining the twin issues of stagnant and falling economic growth with rising food and other inflationary concerns in the developing economies, this is creating an overall stagflation scenario.

The Federal Reserve & Added Liquidity

The Federal Reserve stepped in and introduced extraordinary levels of policy accommodation in order to maintain economic activity and do whatever it takes to keep the economy moving forward.

This was done with Quantitative Easing, the process of buying up bonds and increasing the money supply, as well as lowering interest rates to ultra-low levels.  While these policies have proven to perpetuate the economy in an otherwise economic environment that would have faltered, Combining so much in the form of stimulus as accommodation is leading to excessive inflation.

While I think the stimulus checks were useful, in hindsight, why not have dolled out the funds over the period of many months instead of all at once?  This may have eased the pressure on the supply chain.

Increasing Interest Rates & Decreasing Liquidity

Interest rates are heading higher.  The Federal Reserve has already moved interest rates upward this year and have increased interest rates by 50 basis points at its last meeting. And, after the latest inflation data from the CPI, it is very likely that the next two upcoming meetings, in June & July, expectations are now set for an additional 50 basis points increase.

The market reacted to the latest CPI data by selling off some 5% in two days’ time. 

Now the question becomes: will there be a need for even more interest rate increases and policy accommodation removal?

I think one of the most important things to keep in mind is that economic growth is slowing; hence the stagflation scenario.  While that is happening, inflation is at 40-year highs.  So, the fact that economic activity is waning while inflation is rising means that the Federal Reserve is going to have to work diligently to combat inflation.

This may require significantly higher interest rates to achieve that goal.  And, that would mean targeting much lower economic growth, even negative economic growth, in order to achieve this goal.

Federal Reserve Will Remove $95B per Month

The Federal Reserve has already stated that they are set to remove up to $95B (by August) per month with Treasuries and MBS on the chopping block.  Mostly, the Fed will let these securities roll off.  But, the central bank may move in to actually selling the securities.

The effect of removing so much policy accommodation will mean less liquidity in the economy.

What to Expect

Look for high rates of inflation to persist as more problems driven by the war in Ukraine continue.  We have yet to feel the full effects of the loss in oil supplies as well as the effects of food shortages.  These two issues will continue to ripple through the world economies.

But, these are two things that eventually can be worked on.  Crops can be planted in other parts fo the world.  But, that will move prices upward as it is likely that it will be more expensive to grow the same crops in other parts of the world.  Otherwise, this would have already occurred.

There may be help in the form of Demand Destruction; a term for another day.  But, as prices move too high, gas prices for example, this will mean less demand on these products.  This will alleviate price increases.

I am betting that the stock market is going to be anything but happy over the course of the remaining part of this year.