The threat of U.S. stagflation is looming over global markets, prompting some investors to adjust their portfolios to mitigate the potential impact of tariffs on growth and inflation in the world’s leading economy.
According to an early August survey by BofA Global Research, 70% of global investors foresee stagflation—a mix of slow growth and high inflation—within the next year.
Recent data highlighting U.S. labor market weaknesses, a sharp rise in core inflation, and an unexpected increase in producer prices validate these concerns.
However, global stocks, including those in the U.S., remain near record highs, and bond markets are stable, indicating a lack of panic even as stagflation risks in the U.S. become more apparent.
“Stagflation is on the market’s radar, but not reflected in prices,” remarked Marie-Anne Allier, a fixed income manager at Carmignac.
Here’s an overview of how U.S. stagflation risks might affect global markets.
WATCH OUT FOR BONDS
Persistent inflation, or the fear of it, can undermine longer-dated bonds by decreasing the real value of fixed interest payments over time.
Paul Eitelman from Russell Investments, which manages over $1 trillion in assets, noted that pension funds and insurers are increasingly worried about inflation affecting their bond portfolios.
“Another weak employment report would significantly heighten (U.S. stagflation) concerns,” he added.
Non-U.S. bonds may not offer much protection either.
“Interest rates and the long end of the bond curve are closely linked across G7 economies,” said Mayank Markanday, a portfolio manager at Foresight Group. “A significant selloff in the long end of the U.S. curve is likely to impact others as well.”
There has already been a selloff in long-dated bonds in major markets. While 2-year yields have decreased in the U.S., Germany, and Britain this year, 30-year yields have risen.
If persistent inflation prevents the Federal Reserve from cutting rates this year, short-dated bonds could also suffer.
WALL STREET CHALLENGES
Caroline Shaw, a multi-asset manager at Fidelity International, said the firm expects U.S. growth to slow, with stagflation as one of their two primary scenarios.
While she remains optimistic about U.S. big tech stocks, she purchased derivatives known as put options in mid-July to profit if the more cyclical Russell 2000 small cap index declines.
Like bonds, global stocks are likely to be affected, even if stagflation is limited to the U.S.
Since 1990, global stocks have dropped by an average of 15% when U.S. manufacturing activity data indicated both contraction and higher than average prices, according to Michael Metcalfe, head of macro strategy at State Street.
Yet, stocks continue to surge, which Metcalfe believes suggests investors think “the disruption to the global trading system won’t affect big tech earnings.”
Markets are ignoring bad news and focusing on the positive, said Kristina Hooper, chief market strategist at Man Group.
“It’s like parenting, you only want to see the best in your children, and we’re at a point where markets can do that,” she said.
SELL THE DOLLAR
Nabil Milali, a multi-asset and overlay portfolio manager at Edmond de Rothschild Asset Management, is another investor who believes data shows the U.S. economy is heading toward stagflation.
He anticipates further weakness in the dollar against the euro.
Stagflation poses dual risks for the dollar, Milali said, as weak growth can devalue a currency and persistent inflation erodes its purchasing power internationally.
The euro has gained over 12% against the dollar this year. Other currencies like the Japanese yen and the British pound have also strengthened.
WHAT TO BUY?
This is where it gets tricky, but stagflation could offer another reason to invest in gold, already a favored asset for investors concerned about various risks, said Hooper from Man Group.
Other appealing assets might be short-dated inflation-linked bonds, according to Foresight Group’s Markanday.
Professional investors are also turning to complex derivatives like inflation swaps, which increase in value when price indices surpass a certain level, Eitelman from Russell noted.
The U.S. two-year inflation-linked swap is near its highest point in over two years.
