What You Need to Know
- Late-cycle alarms ringing now include ongoing concerns about inflation and how the Federal Reserve will react.
- Thus far, there are more differences than similarities between the inflation of today and 1970s-style stagflation.
- Advisors and their clients should keep a close eye on the correlation between bond yields and stock prices.
“There are some late-cycle alarms that have been ringing lately,” including ongoing concerns about inflation and how the Federal Reserve will react, Liz Ann Sonders, chief investment strategist at Charles Schwab & Co., said Tuesday during the virtual Schwab Impact conference.
She has been pondering lately whether the COVID-19 pandemic-driven recession has “been a traditional recession in the sense that it launched a new economic cycle, or might it be more aptly thought of as a war that interrupted an ongoing economic cycle” — or maybe it’s “something different altogether,” she told viewers.
Below are a few of the main things that advisors and their clients are or should be concerned about now, according to Sonders.
1. Ongoing inflation leading to stagflation.
“The key question is whether COVID’s toxic brew and its impact on global supply chains is a setup for 1970s-style stagflation,” according to Sonders. But, thus far, “there are more differences than similarities,” she said.
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After all, she explained, the “purest definition of stagflation includes high and rising unemployment — clearly, in contrast to today’s extremely tight labor market, while productivity is much stronger today as well.”
Meanwhile, “secular forces tend to shift and create either a prevailing inflationary or deflationary backdrop,” she said. But she said: “Psychology also comes into play when the psyche of workers and companies change and each decides they can use their power to demand higher wages [and] pass on higher costs persistently. That’s when the so-called wage-price spiral kicks in.”
Not all inflation is the same, she went on to explain. “There are two broad categories of inflation. Procyclical inflation occurs when stronger economic activity drives prices up. Countercyclical inflation occurs when high prices drag economic activity down.
“I think a risk is that we have shifted from procyclical to countercyclical inflation. And, for now, we have moved from an age of abundance to an age of scarcity. Interdependencies, low inventories across global supply chains have created a pretty fragile system that’s become more vulnerable to shocks and their ripple effects, including the global energy crisis.”
2. The Fed’s reaction to ongoing inflation.
What remains to be seen is what the Fed’s reaction will be, according to Sonders. “We all know that central banks’ policy tools can do little to ease bottlenecks in the global supply chain but a risk is that the Fed will have to tighten policy more quickly than anticipated to quell demand,” she warned.
However, she pointed to a potential, “more benign scenario” also: that “high prices cure high prices with lower demand; in other words, might inflation protect us from the Fed before the Fed feels it has to protect us from inflation?”
When it comes to Fed policy, “there may be no precise or mechanical link between” quantitative easing (QE) and asset prices but “clearly the Fed’s ongoing promise of liquidity has had important psychological impacts,” she said. “This is why concerns about the coming tapering remain front and center for equity investors.”