Analysis-Oil Price Surge Revives Wall Street Fears Of 1970s-style Stagflation

With surging oil prices, concerns about the hawkishness of the Federal Reserve and fears of Russian aggression in Eastern Europe, the mood on Wall Street feels like a return to the 1970s. Other than bell-bottoms, the only thing missing so far is stagflation, which occurs when an economy experiences rising inflation and slowing growth at the same time.

Yet some investors now think that it is not far off.

They are recalibrating their portfolios for an expected period of high inflation and weaker growth.

Sanctions on top commodity exporter Russia have helped lift the price of Brent crude by some 80% in the last year to around $116 a barrel, stoking concerns that higher energy costs will continue pushing up consumer prices while pressuring global growth.

At the same time, market volatility stemming from geopolitical strife has made investors less certain over how aggressive the Federal Reserve will be in tightening monetary policy to tame soaring inflation. Investors now expect the Fed to take rates from zero to 1.5% by February 2023, compared with 1.75% or higher just a few weeks ago. [FEDWATCH]

The percentage of fund managers who believe stagflation will set in within the next 12 months stood at 30%, compared with 22% last month, a survey from BoFA Global Research showed.

"Our base case is still not 1970s stagflation, but we're getting closer to that ZIP code," said Anders Persson, chief investment officer of global fixed income at Nuveen.

The threat of stagflation is especially worrisome to investors because it cuts across asset classes, leaving few places to hide. A diversified portfolio of global equities, bonds and real estate could end up losing 13% in the event that rising oil prices cause stagflation, according to a stress test model by MSCI's Risk Management Solutions research team.

The last major stagflationary period began in the late 1960s. Spiking oil prices, rising unemployment and loose monetary policy pushed the core consumer price index up to a high of 13.5% in 1980, prompting the Fed to raise interest rates to nearly 20% that year.

The S&P 500 fell a median of 2.1% during quarters marked by stagflation over the last 60 years, while rising a median 2.5% during all other quarters, according to Goldman Sachs.

With bond prices hit by recent market volatility, Persson is looking for opportunities to position in high-yield debt, which he believes may be a good hedge against future stagflation-fueled declines.

Worries that stagflation may hit Europe harder due to its heavier reliance on energy imports will likely cause some investors to edge away from the region's assets, said Paul Christopher, head of global market strategy at Wells Fargo Investment Institute. Moving out of U.S. assets and into European ones became a popular trade near the end of 2021, as U.S. stocks rose to comparatively high valuations.

OPPORTUNITY IN COMMODITIES

Stagflation in Europe would likely resemble the long period of low growth and high inflation the United States experienced in the 1970s, Christopher said.

"In Europe, if energy prices go too high then factories will have to shut down," he said.

Nuveen's Persson estimates that a Brent crude price of $120 per barrel will sap 2 percentage points from the economy of the EU. Rising oil prices will likely shave 1 percentage point from the U.S. economy, due in part to the country's greater domestic supply and lower taxes.

U.S.-focused equity funds have gained $44.5 billion in inflows since the start of February, while world stock funds have pulled in, losing $2 billion in outflows, according to ICI data.

Funds focused on commodities have notched $7.7 billion in inflows since the start of the year, including the largest one-week net gain since August 2020, ICI data showed.

Those inflows have come amid sharp price gains in raw materials that have benefited assets linked to commodity exporters such as Australia, Indonesia and Malaysia.

"We see a long wave of opportunity in commodities that we haven't seen in a long time," said Cliff Corso, chief investment officer at Advisor Asset Management.

His fund has been building positions in commodities and emerging market equities from oil-rich countries such as Mexico as a hedge against the potential of higher inflation or stagflation.

A robust job market and domestic sources of energy should leave U.S. equities, especially dividend-paying companies, more attractive than other global assets even in the face of rising inflation, said Lindsey Bell, chief markets and money strategist at Ally.

"The consumer remains healthy and has been able to absorb higher inflation thus far," she said.