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The Fed’s Least Favorite Word
The recently released 1st quarter GDP print, which showed both a substantial slowdown from previous quarters and stubbornly high underlying inflation data, has recently sent alarm bells ringing concerning the Federal Reserve’s least favorite word… stagflation. Stagflation is the combination of a high rate of inflation, slow economic growth, and, in some definitions, high unemployment. The problem with stagflation for the Federal Reserve is that the ways to fight the two primary problems – high inflation, low growth – usually end up making the other one worse. Central Banks can increase interest rates to reduce inflation or cut interest rates to spur growth, but they can’t do both at the same time.
Fed Chair Powell, at least on the surface, is not concerned. When asked about the possibility of stagflation during last week’s FOMC meeting he said he "doesn't see the ‘stag’ or the ‘flation’." While he may not see it, people are certainly taking note, as the chart below shows. News stories referencing stagflation have spiked in recent weeks, hitting their highest level since June 2022.
Source: BofA Global Research as of April 25, 2024
Rather than take the Chairman’s word for it, let’s examine the key criteria for stagflation to assess where things stand today and what we can expect going forward.
Criteria 1: High Rate of Inflation
Stagflation concerns began with the March CPI release, which increased 0.4% from February, and 3.5% over the last 12 months, higher than forecast and the second monthly miss in a row (February was up 3.2% compared to 3.1% expected). While these numbers are not “high” by stagflation standards, the concern is the trend, which had been on a steady decline from the June 2022 high of 9.1%, but has leveled off at best over the last six months.
While the recent increase is worth noting, as we mentioned in our February 2024 Insights, we believe much of persistent inflation has come from stickier components of the calculation that are set to come down, providing a tailwind for lower inflation readings in the months to come. Shelter in particular, which accounts for 42% of the Core CPI calculation, is set to drop on lower rental prices through the second half of the year. Shelter has contributed 2%+ to topline inflation since October 2022. A significant drop would be particularly meaningful in getting the recent inflation trend to end.
Source: Morgan Stanley Research as of March 31, 2024
Criteria 2: Slow Economic Growth (GDP)
Stagflation concerns really took hold with the release of Q1 advance estimates for Gross Domestic Product (GDP), which came in at an annual rate of 1.6%, well short of expectations and ending a run of six straight quarters of growth above 2%.
The initial estimate of GDP in any given quarter is based on highly incomplete source data and, as such, is prone to sizable revisions. Inventories and trade tend to be the most volatile components of GDP and had a meaningful impact on the Q1 advanced estimate, with Net Exports detracting -0.9% from the overall number alone. If we view the report from a purely domestic perspective, focusing on household and business spending, results are much more encouraging. The first quarter saw an annual rate of 3.1% for the quarter, relatively in line with the positive trend and only slightly lagging the 4th quarter result of 3.3% (chart below).
Source: Bureau of Economic Analysis (BEA), Bloomberg Finance L.P. as of March 31, 2024
Criteria 3: High Unemployment
Arguing that we have high unemployment today is difficult even for the most fervent stagflation forecasters. While we did see a slight uptick in the unemployment rate in the Bureau of Labor Statistic’s April Report (3.9% from 3.8%), it’s hard to categorize that as high. In fact, April marked the 27th consecutive month of the unemployment rate staying below 4% (chart below), the longest such streak since 1970. We will note however that the worst bout of stagflation in modern US history came on the heels of the 1970 streak ending, also coinciding with the start of a recession. Unemployment is not high today, but it doesn’t mean it can’t get there quickly.
Source: Charles Schwab, Bloomberg as of April 30, 2024
Outlook: Earnings Growth
Putting aside our often-used mantra that “The Market is Not the Economy”, looking at projected earnings growth may shed some light on at least one component of the stagflation formula: growth. Over the last 50 years, there has been a positive relationship between EPS (earnings per share) growth and real GDP growth in the US (chart below).
Source: Refinitiv, Schroders Economic Group as of October 31, 2023
The good news on this front is that earnings growth has been strong in Q1, with an average 5% EPS growth for S&P 500 companies through last week (77% reporting). Even more encouraging, consensus estimates expect a significant increase in EPS growth through the remainder of the year, projecting an impressive 20% acceleration between the first and fourth quarters of 2024 (chart below).
Source: Thomson Reuters
While recent signs have pointed to each of inflation, growth and employment heading in the wrong direction, there are many positive signs that we are not on the precipice of stagflation, at least not anytime soon. However, as was the case in the 1970’s, things can change quickly, and remaining nimble in your investment portfolio is necessary in the face of an ever changing economic landscape.
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