Over the past month, we’ve seen growing commentary about the possibility of stagflation, exacerbated by a flattening of yield curves. Stagflation is not a central case in our outlook, but clearly investors regard it as more of a risk, so it should at least be discussed for holistic portfolio planning.
We distinguish between tactical stagflation and a strategic case for stagflation. Over tactical horizons—the next 12 months—growth and inflation might evolve to a period where inflation and growth rates “cross over.” But we don’t think this really counts as stagflation in any traditional sense: the absolute growth level will still be very high, given current high demand. And we still believe that the exceptionally high inflation levels, by some measures, are transitory.
Room for a Higher-Inflation Scenario
A bigger question for asset owners is whether the macro landscape points to a possibly longer stagflation period over the next three to five years, which would be a major shock to current strategic asset-allocation assumptions. This scenario wouldn’t be driven by the temporary supply/demand shock fueling exceptionally high short-term inflation, but by the longer-term prognosis for growth and inflation.
How likely is this scenario?
We’ve made the point several times that strong inflationary and deflationary forces exist over strategic horizons. In our central case, these forces lead to equilibrium inflation that’s above the pre-pandemic level but still in “moderate” territory. However, no one knows what coefficients to put on these forces, because we’ve never been in this state before. That leaves room for a higher-inflation outlook, which requires watching for several key forces—in the strategic, not tactical outlook.
Strategic Forces That Could Stoke Higher Long-Term Inflation
An ongoing demographic transition implies a shrinking global labor force (excluding Africa, at least), which will likely undo a significant portion of labor-supply growth that occurred in the wake of former Soviet countries and China joining the global economy. This could imply stronger wage bargaining power in the medium term. There’s a lively debate about how much of this is likely to be offset by automation, especially given indications that investment in automation has accelerated in the pandemic era.
A force that could drive wages up faster than demographics is change in social and political mores—notably the narrative about the relative power of labor and capital as well as the “leveling up” agenda in terms of wage inequality. These forces seem set to materially affect the wage distribution and increase labor’s share of gross domestic product (GDP) in coming years. As we’ve discussed before, this could lead to some form of universal basic income, which could mechanically set a higher path of inflation. Putting this in the language of the investment industry today: ESG is inflationary.
Above and beyond this, the pandemic’s legacy of higher debt levels and the ability to deploy fiscal policy as the key offset to economic slowdowns could alter the inflation calculus. We view imposing austerity in major economies as politically impossible, so over the medium to long term, politicians (though not central bankers) will likely look more favorably on higher inflation as a way to manage down debt levels, which, as a percentage of GDP, are now the same as they were at the end of WWII across the countries in the Organisation for Economic Co-operation and Development.
Moreover, the fiscal genie is out of the bottle. Whenever the next downturn comes, there will presumably be intense pressure on fiscal policy to provide support. There’s a debate about whether this would count as Modern Monetary Theory (MMT) or not—we believe that this is slightly beside the point and merely semantics. It’s highly unlikely that MMT will be explicitly adopted as a stated policy in a major economy because it would require too much rebuilding of institutions. However, quasi-MMT language could be influential and used as a description to craft policy.
Defining Stagflation Scenarios—and Asset Responses
None of this necessarily leads to higher inflation as there are offsetting forces, but for those who worry about stagflation, these are the narratives to watch. In the near term, a key metric is how this wariness feeds into expectations of inflation, which have been increasing (Display).