In brief

• A potential ban on Russian energy imports by Western nations has led to a surge in prices, fueling stagflation concerns.
• Different regional starting points for inflation, labor markets and the business cycle will influence the size of any stagflationary impulse.
• Central banks are likely to look through the supply shock of higher energy prices as they normalize rates. 

The events of the last few weeks have rekindled the stagflation thesis and the potential for a repeat of 1970s-style stagflation. Falling bond yields in response to growth concerns has led to a flattening yield curve as markets start to price a stagflationary outcome. The spread between the 10-year and 2-year U.S. Treasury yield fell to 24bps in the first week of March, its narrowest in two years. However, rather than focusing on whether the global economy is headed for stagflation, it is better to consider the magnitude of the stagflationary impulse within different regions, as they will not be the same.

A previous note (Are we entering a period of stagflation?) discussed whether the global economy was on the cusp of stagflation. While we continue to believe that the global economy will avoid outright stagflation, we recognize that current events will create a stagflationary impulse. This impulse will not be felt evenly across the globe. The starting point of the business cycle, the current level of inflation and labor market dynamics will influence the mix of growth and inflation in each region.

Most developed markets headed into this year riding a wave of fading Omicron cases, the removal or at least a reduction in mobility restrictions and expectations of a pick-up in consumer spending given the still healthy position of household balance sheets and tight labour markets.

These factors create a buffer to the current energy price shock, but are not enough to offset it. Europe is likely to face the greatest stagflationary impulse given the elevated rate of inflation and the far larger risk of recession. The impact on household spending from rising energy costs, the possible retrenchment in corporate activity in the face of increasing uncertainty and rising levels of unemployment build the case for stagflation.

The U.S., just like Europe, is experiencing elevated rates of inflation, but has a higher degree of energy autonomy and more robust labor market. Even if job growth slows in the U.S., the current elevated demand for labor will lessen the drag on economic activity. Meanwhile across Asia, inflation rates are relatively low and the growth prospects better given the region is in in the earlier part of its economic cycle. 

Exhibit 1: Market-based inflation expectations
5-year 5-year and 1-year 1-year inflation swap rates

Source: Bloomberg Finance L.P., J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results.
Data reflect most recently available as of March 4, 2022.

The regional variation is captured in revisions to the economic growth forecasts for this year by J.P. Morgan Economic Research. The forecast for eurozone GDP has been cut by 2.1% for the final quarter of this year to 2.5% compared to the year prior. Meanwhile, EM Asia ex-China has had a much smaller 0.3% cut from growth expectations to 5.0%, and the U.S. growth a marginal 0.1% shaved from its original 4Q22 growth rate expectation of 2.8%.

There is a clear downside risk to these growth figures should the oil price remain higher for longer than anticipated. For example, the loss of Russian oil supply which is not cushioned by an increase in supply from the Organization of Petroleum Exporting Countries, the release of strategic reserves nor the addition of Iranian oil could see global growth cut by 3% in 2022 and push the global growth rate close to zero.

Stagflation is often described as the worst of both worlds for central banks and their trade-off of reining in inflation or supporting growth. Markets are justified in their concerns of central banks making the wrong policy choice at this juncture.

Our view is that if pressured, central banks are likely to protect growth at the expense of inflation coming from a supply shock. However, second-round effects, such as a wage price spiral and the de-anchoring of inflation expectations, could lead to a more aggressive stance as central banks act to maintain credibility.

So far, inflation expectations remain anchored. Exhibit 1 illustrates the short- and longer-term market view on inflation for the U.S. In the near-term, inflation expectations have jumped to 5%, while the longer-term inflation expectations have moved with a fairly steady range and have not deviated too far from the U.S. Federal Reserve’s target.

The fiscal response will matter as well. Government’s renewed willingness to spend to support the economy in times of crisis could cushion the impact on households from rising energy prices, shielding discretionary levels of spending and consumption. This may give central banks more leeway to address inflation in a weaker growth environment. However, in the case of the European Central Bank (ECB), we now expect them to maintain the current policy settings for some time.

Investment implications

Markets are repricing for lower growth, higher inflation environment and the spectre of stagflation. The stagflation impulse will be greatest in Europe compared to the U.S. or Asia.

This means that the policy response will change. Governments are likely to step up fiscal support to shield households from rising energy costs, but for central banks, with the exception of the ECB, to continue with plans to normalise policy rates.

The high degree of uncertainty over markets and just how long the current environment may last implies greater diversification and balance in portfolios is needed rather than large shifts to underweight risk assets or overweight defensive ones such as government bonds. 

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