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Insights   > Market Outlook - It’s Not Stagflation

Market Outlook - It’s Not Stagflation

The U.S. is not currently experiencing stagflation, and it’s not going to over the next couple of years. The debate about stagflation is going to intensify over the next few months as growth in consumer prices continues to accelerate. However, there are a ton of temporary factors behind the acceleration and recent gains in the CP Iare concentrated in the most volatile components. This is likely not sustainable; it is attributable to the reopening of the economy.Still, a stagflation debate will occur, and there won’t be a consensus. Some define stagflation as weaker growth and accelerating inflation. The weaker-than expected job growth in April and string of disappointing economic data coupled with the April CPI have some believing their criteria for stagflation has been met.However, we believe this definition is too loose. Periods of stagflation occur when there is high unemployment and high inflation. Inflation isn’t high. We calculated z-scores—a measure of the standard deviations above or below the mean—for the headline and core CPI, and they are the highest since oil prices jumped in 2008. The z-score is at the top end of the range seen between 1991 to 2008 but well below that seen in the 1970s and1980s. Another way to assess stagflation is using the misery index, which was invented by economist Arthur Okun in the 1970s as a way of expressing his frustration at the two main economic problems of the day: high unemployment and high inflation, or stagflation. The misery index was 10.3 in April, among the highest since 2011, but that wasn’t stagflation then and it’s not now. Based on our forecast for inflation and unemployment, the misery index will steadily decline over the next few years.Things can change, but we don’t believe stagflation is in the economy’s near future. Stagflation in the 1970s occurred because the economy was juiced-up by the Vietnam War and Great Society spending, the job market tightened,wage growth accelerated, and businesses jacked up prices. This was the genesis of the runaway inflation of the 1970s and early 1980s, which was exacerbated by Arab oil embargoes and spiking oil prices, and the Federal Reserve’s initial mishandling of the accelerating inflation.

The role of inflation expectations wasn’t well understood then, and the Fed didn’t realize expectations were becoming unanchored. Fed officials were more worried about the negative fallout of the higher oil price on the economy’s growth than the impact on inflation and expectations. It kept interest rates too low for much too long. The slow growth and high inflation of stagflation set in, and that period ended poorly.

The Fed decided it had no choice but to crush the high inflation and inflation expectations by pushing interest rates into the double digits and causing the economy to suffer the severe double-dip recessions of the early 1980s. That draconian policy worked. A decade later, inflation had been contained, but the economic cost was great. We are still paying for it in the skewed income and wealth distribution.

The Fed has learned its lesson and it has all the tools to address this period if transitory inflation proves to be something else. The risks of stagflation are low.

Some softening in issuance

U.S. investment-grade issuance came in lighter than expected in April, and May isn’t shaping up to be much better. Worldwide investment-grade corporate bond issuance totaled $213 billion in April, compared with the $447 billion last April. U.S. dollar-denominated investment grade bond issuance was $135 billion in April. This would be down 41% relative to 2020. However, it wasn’t going to duplicate the torrid pace set last year, but the good news is that issuance remains in line with that seen in 2018 and 2019.

So far, investment-grade corporate bond issuance in Mayhas totaled $66 billion. The pipeline for the rest of the month suggests that total issuance for the month should be close to that seen pre-pandemic. With April issuance and a fairly good reading on May’s, the expected total IG issuance for this year is now tracking $1.28 trillion.

April was another strong month for high-yield issuance, as it totaled $60 billion, stronger than the issuance seen last April. In fact, compared with its average over the past five Aprils, issuance this April was 45% larger. Year-to-date high yield issuance is $298 billion. This puts high-yield issuance on track to be just south of $700 billion this year.

High-yield corporate bond issuance has largely been earmarked to refinance existing debt at lower rates. With the substantial amount of refinancing, the high-yield market feels less risky than it has in the past as default risk is lower. This also has some economic benefits. The share of nonfinancial corporate debt has grown from around 40% of GDP in 2011 to more than 50% in 2021 and the risk of that debt, as measured by credit ratings, has increased. Firms that are more indebted will normally face higher interest rates as the economy recovers or if there is a stock market correction. This drag on hiring and investment could be less significant than in the past.

Risks to high-yield issuance are weighted to the downside.Market volatility could pick up in the second half of this year as the Fed’s debate about tapering its monthly asset purchases begins and there is a possibility of a higher capital gains tax rate next year.

We have updated our expected timeline for tapering. Wes till expect the Fed to announce its tapering plans in September and the $15 billion reduction to occur at each Federal Open Market Committee meeting in 2022. The Fed has signaled that it wants tapering to be on autopilot.

Once its monthly asset purchases have been reduced from $120 billion to zero, the Fed will reinvest proceeds from maturing assets to ensure its balance sheet doesn’t contract, which would be contractionary monetary policy.

No revision to GDP, corporate profit margins compress

Revisions to first quarter U.S. GDP were not eventful. First quarter GDP rose 6.4% at an annualized rate, identical to the government’s advance estimate. However, we did get our first look at corporate profits in the first three months of the year and they were unchanged, compared with the fourth quarter of 2020.

Corporate profits were 12.7% on a year-ago basis in the first quarter. Base effects boosted year-over-year growth incorporate profits in the first quarter and will continue to do so this quarter. Pre-tax profits as a share of GDP, a proxy for corporate profit margins, slipped to 10.4% in the first quarter, which is roughly in line with that seen before the pandemic. Margins are slightly below their 5- and 10-year averages. Still,businesses have the ability to absorb some of the price pressures that have developed because of rising commodity prices and global supply-chain issues.

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