Earlier this month we saw volatility spike as markets repriced recession risk, giving investors unpleasant flashbacks to 2022. However, unlike in 2022, it seems the market believes the greater risk lies today in a typical garden-variety ‘recession’ and not in the much rarer but more pernicious ‘stagflation’. While we continue to believe that the market is going to avoid both of these tough market outcomes in the near-term, a big part of our proactive risk process is summarizing possible broad economic scenarios, the conditions for their occurrence, and their impact on the economy and corporate earnings. From there, we continually update our likelihood of each scenario as new data becomes available. In this Strategic View, we will dig into two of the most market-negative (and unlikely in our view) outcomes – recession and stagflation - defining them and discussing their ramifications.
Recession vs. Stagflation
When looking at a typical disinflationary recession and a stagflation scenario, their commonality is that inflation-adjusted (aka “real” in economist parlance) economic activity declines in both scenarios. Looking at Figure 1, we can begin to see the differences between these two scenarios:
Chart shown for illustrative purposes only. Past performance is no indication of future results.
The major differentiator between the two scenarios is inflation levels, and the Federal Reserve’s ability to respond to slowing growth with interest rate cuts and stimulus. For a standard recession, slowing economic growth reduces aggregate demand, which reduces inflation over time.
On the other hand, stagflation is the combination of economic STAGnation and inFLATION. While a much rarer occurrence – stagflation has only occurred once in the last century, during the 1970s and early 80s -, this particular combination of economic factors creates a very difficult investing landscape. The key to understanding why these two tough scenarios are different is understanding that the Fed has a dual mandate to both balance full employment and control inflation. During a typical recession, unemployment rising and inflation falling may give the Fed license to enact expansionary policies, such as rate cuts, to help stimulate both economic growth and inflation. However, given that inflation would be above its’ target during stagflation, the Fed’s decision becomes much less clear. They must either pursue policies to reinvigorate the economy or policies to reduce inflation…two actions that are often mutually exclusive. If they were to cut rates, economic growth may reaccelerate, but they would risk having inflation run rampant. On the other hand, continuing with restrictive policies would hopefully keep inflation in check, but the economy might remain sluggish for a prolonged period. We believe it is this difference in the Fed’s potential response that truly differentiates these two investment scenarios.
Ramifications of Recession vs. Stagflation: Bonds Not a Ballast in Stagflation
While the major economic recessions in 2008/9 and 2020 had very different causes, both resulted in significant bear markets for stocks. Stock markets traded down indiscriminately, with more defensive sectors such as consumer staples tending to perform relatively better than broad indexes, though still negatively. With the Fed pivoting to expansionary policy, long maturity treasury securities helped provided ballast to balanced portfolios, whereas high yield corporate bonds traded down in concert with equities as credit spreads widened. In a typical recession, we believe that if the Fed is able to cut rates and provide a bit of a safety net, stocks can find a bottom relatively quickly (usually within 12 months).
Moving to stagflation, we believe that equity markets would broadly sell off similarly to recession, though we believe sector relative performance may differ. While we believe defensive sectors would perform best in a normal recession, in a stagflation scenario energy and other commodity-and real asset-related equities would likely be relative winners. However, the bigger difference is the Fed is no longer firmly on the bond investors’ side in stagflation. This means that long maturity bonds would no longer provide protection to balanced portfolios during stagflation. We can look to 2022 to see this in action. When markets began to fear runaway inflation and started to price in a higher probability of stagflation, we saw the worst year for the traditional ‘60/40’ balanced portfolio in decades. This negative outcome was partly due to the exceptionally low interest rates at the beginning of 2022. While rates are higher today than 2022, in a stagflation scenario, investors would still need to look at alternative options for portfolio protection. These alternatives, in our view, include short maturity treasury inflation-protected securities (TIPS) and commodities, both direct and via equity exposure.
CONCLUSION: We Believe Neither Negative Scenario is Likely
To start, we do not believe either recession or stagflation is a likely outcome. As discussed in last week’s Weekly View, we place less than a 30% probability combined for both scenarios over the next 6-12 months. With recent lower inflation data and a more dovish tone from the Fed, we view a recession as more likely than stagflation if markets begin to trend downward, and our portfolio positioning broadly reflects this belief. Our fixed income positioning reflects our lower concern around the probability of stagflation relative to a garden-variety recession; we view long maturity bonds as a good tail risk hedge and have Treasuries and Investment Grade Credit in the 10+ year part of the curve as a hedge for this outcome. Specifically, we view ten-year rates within a range of 3.75% and 4.75% as attractive prices for this protection.
However, if inflation begins to reaccelerate meaningfully, or if we see a large spike in commodity prices, our perceived chance of stagflation would rise as well, leading us to consider TIPS and/or commodity exposure for the portfolio. Since we view a recession as the more likely negative outcome, typically defensive equities would be positioned as potential partial ‘tail risk’ hedges. However, we currently view most of these sectors as overvalued or overly reliant on interest rates to drive their returns. Instead, we prefer to focus our defensive positioning on alternative equity strategies. These strategies sacrifice some of the upside of equity markets for more current income. This income can provide ballast to portfolios should markets make a downturn.
Given we do not foresee these negative outcomes, we remain overweight equities in our portfolios. We remain overweight large cap technology, relative to our global benchmarks. In a reflationary scenario, we would expect market breadth to increase, specifically in typically value-oriented sectors.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.
