Global stock markets have regained some sense of calm after a tumultuous month in March, but government bond markets are flashing warning signs about the growing risks of stagflation. Level-headed investors should heed these warnings and take action now to navigate what is turning out to be a turbulent year.
Stagflation is a debilitating combination of persistently high inflation with low economic growth, and the evidence suggests that stagflationary dynamics will dog the global economy for longer than some investors expect.
Inflation is already at multi-decade highs in the US and UK, and in Europe, inflation is at a record high. Consumer prices are expected to rise further still as the war in Ukraine pushes up the prices of oil, gas, wheat and other commodities, which threatens consumer spending. The lockdowns in China’s economic hubs will delay shipments of vital goods, placing additional constraints on global supply chains and placing further upward pressure on consumer prices.
This mood is captured in Fidelity’s 2022 Analyst Survey, which shows that more than two thirds of our analysts expect inflation to be higher this year compared to last year, driven by a combination of both temporary factors and long-term structural changes to the global economy.
Our annual survey showed that inflation expectations were highest for Europe, with 84% of analysts who cover European companies saying they expected prices in the bloc to be higher this year. Of the analysts surveyed, 76% expect US prices to be higher this year.
In contrast, inflation expectations for China were the lowest, with less than 40% of analysts surveyed saying they expected prices to rise. Inflation expectations for Asia Pacific, excluding China and Japan, were also on the low end, according to the survey.
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The impact of rising commodity prices cannot be overstated, as this threatens to unleash a cost-of-living crisis for a broad range of households in both advanced and emerging economies. Tighter fiscal conditions in some countries will exacerbate the squeeze on consumer spending.
China’s southern manufacturing and technology hub of Shenzhen is emerging from a lockdown, but another lockdown in Shanghai, also a centre for manufacturing and finance, is a reminder that lockdown raises the prospect of more supply chain issues that will add to price pressures and contribute to stagflationary dynamics.
Labour shortages in the West, which emerged as their economies bounced back from the pandemic, will also contribute to upward pressure on prices for both companies and consumers, the analyst survey showed.
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More than 42% of analysts polled said that inflationary pressures are due more to temporary factors, but geopolitical tensions have complicated this picture and have complicated policymakers’ response to rising prices.
Pressure to hike rates
The US Federal Reserve and other major central banks are under pressure to raise interest rates high enough to curb inflation, but moves in the US Treasury market show there is a chance that the current expected pace of rate hikes may cause strong recessionary pressures in the US or beyond.
The Fed, and to a lesser extent the European Central Bank, may both be forced to slow down their pace of rate hikes due to concerns about economic growth, but stagflationary dynamics will remain a risk as they balance their inflation fighting credibility with that growth aspect.
At the other end of the policy spectrum, Chinese authorities have already indicated that they will continue to lower interest rates to ease monetary conditions and offer more stimulus for the economy. Less inflationary pressure means China has more room to focus on supporting growth, which tends to support other emerging markets.
While the mood may seem sombre, at Fidelity, we believe that there are also opportunities for investors to diversify and manage downside risks that lie ahead this year. Our core view is investors should look for areas of the market that are less impacted by stagflationary dynamics. In the near term, we remain cautious on risk assets in equities and credit. Within credit, we are positioned defensively — we overweight investment-grade and prefer Chinese government bonds on the expectation of more policy easing.
Other emerging markets, such as Asean areas and India, may also prove resilient. Thematically, we look to capture upside in the push of the EU into more renewables and likely upswing in cybersecurity demand. In the foreign exchange market, we have focused on increasing exposure to the dollar due to expectations for higher rates, but we underweight the euro, partly due to downside risks posed by disruptions to the global energy trade.
Over the long term, inflation in the West will eventually peak out, which will relieve the pressure on central banks to tighten monetary policy. The outlook for China is also a reason for optimism. However, we remain cautious of potential tail risks and prefer to be underweight in riskier assets in the near term.
Matthew Quaife is head of Multi Asset Investment Management, Asia Pacific, at Fidelity International
