Investors underestimate stagflation risks: Deutsche

  • Markets are underpricing the risk of stagflation in a 1970s fashion, according to Deutsche Bank in a note.
  • The bank reports consistently high inflation data, which could lead to elevated inflation expectations.
  • This would lead to an even stronger response from the Fed, which would lead to more difficulties for stocks and bonds.

Markets are seriously underpricing the risk of 1970s-style stagflation, Deutsche Bank said, warning investors could face negative long-term returns in both stocks and bonds.

Soaring inflation has helped trigger a strong sell-off in the market this year, with the S&P 500 now 25% below where it started in January. Some market bulls have signaled an easing of inflationary pressures, which could fuel a rally before the end of the year – but these investors are underestimating the risk that inflation will take root in the economy, the lender warned on Monday. Deutsche analyst Henry Allen in a note, which could bring more headwinds to stocks and bonds.

“Markets overlook the fact that we are increasingly at risk of reverting to prolonged 1970s-style stagflationary momentum, which would require an even greater interest rate reaction. If the experience of the 1970s repeats itself, investors expect a prolonged period of negative real growth in yields for bonds and equities,” Allen said.

Allen pointed to the fact that inflation has remained high for a significant part of this year, with the consumer price index hitting a 41-year high of 9.1% in June and only falling back to 8.2%. in September. Additionally, “sticky” prices – prices for goods and services that do not change frequently – continue to accelerate in the economy.

These indicators are “very bad news,” Allen said, because the longer inflation remains, the more inflation expectations are likely to take root in the economy. He pointed to recent data from the University of Michigan, which found that three- and five-year inflation expectations had risen, despite back-to-back declines in previous surveys.

“It is true that this could only be a blow, but another reversal would raise the question of whether the Fed’s actions to date have proven insufficient,” Allen warned.

There is also evidence that Fed policy is not yet restrictive enough to fully control inflation. Despite aggressive rate hikes this year, the Fed’s key rate remains “deeply negative in real terms,” ​​Allen said. He reckons it’s even lower than the real policy rate that was in play when the US battled inflation in the 1970s – which led to the economy plunging into a deep recession in the early 1980s. .

And while some argue that inflation was triggered by idiosyncratic factors, such as the pandemic and Russia’s invasion of Ukraine, this does not rule out other idiosyncratic events further fueling inflation, Allen warned.

“As in the 1970s, seemingly transitory shocks have combined to keep inflation high. We cannot rule out that more will occur,” he said.

His view echoes the warnings of other experts. Economist Nouriel Roubini has warned that the United States could face a stagflationary debt crisis, which he says could wipe out up to 40% of the stock market’s value.

“This is not an unnecessary warning. Inflation has become increasingly widespread and persistent,” Allen added.

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