Addressing Misguided Concerns About Stagflation

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

The major indices finished the first half of the year on a down note as the two questions gnawing at investors for months — how quickly inflation will ease and whether pressures will subside fast enough that the Fed won’t be forced to tighten the U.S. economy into a deep recession — took on a new wrinkle. The latest twist has investors wondering if the impact of the Fed’s efforts will result in a scenario last seen in the 1970s, when inflation remained high even while the economy contracted.

The narrative, in our view, is based on an incomplete reading of what led to stagflation in the ’70s as well as a market that is focused on headline year-over-year data at the expense of recognizing steady improvements in the monthly numbers.

Two factors that played a significant role in inflation’s staying power nearly 50 years ago were steady wage gains that partially offset higher prices and consumers who believed they were facing a never-ending upward spiral of rising costs. While wage gains have been robust over the past year, expectations for future increases are at just 1.1 percent, according to recent results from the University of Michigan Consumer Sentiment Survey. By contrast, workers from 1969 through 1981 saw wage increases of between 6 and 9 percent annually. Likewise, despite a brief upward blip last month in expectations of inflation five years into the future, consumers have tempered their views of cost increases in the medium term. As we’ve noted in recent commentaries, expectations are important because they influence buyer behavior. Put another way, the fear of ever-escalating prices causes heightened demand as consumers act to avoid paying higher prices for the same goods in the future.  

Recognizing that the current economic backdrop lacks some of the elements that allowed stagflation to take hold also helps cast recent economic data in a more accurate light. By most measures the economy is growing, but the pace of expansion has continued to slow. While uncomfortable, the easing of demand is necessary to help right the supply/demand imbalance that took hold during the height of the COVID pandemic. And while we acknowledge the slowdown could result in a recession in the coming quarters — and the equity markets appear to already be pricing in a mild recession — we believe consumers and corporations are financially strong and that any contraction would be shallow and short-lived.

Wall Street wrap

A downshift in core inflation. Consumers continued to see some easing of inflation, according to the latest Personal Consumption Expenditures (PCE) price index from the U.S. Commerce Department. The index, which is the Federal Reserve’s preferred measure of rising prices, shows core inflation eased to 4.7 percent year-over-year in May, down from April’s 4.9 reading and .6 percent lower than its February high. Core inflation excludes volatile gas and food prices. However, headline PCE, which does include those items, came in at 6.3 percent — unchanged from the prior month but lower than March’s 6.6 percent year-over-year expansion.

The report also showed a slowdown in spending as well as a continuation of recent trends of consumers putting money toward services and shying away from goods purchases. Goods spending, adjusted for inflation, is still 13 percent above its pre-COVID levels, while services expenditures are 0.5 percent higher during the same period; however, that trend has clearly shifted. Goods spending, as a reminder, marched higher throughout the worst of the COVID lockdowns but has fallen 5.7 percent since much of the country reopened in March 2021. Conversely, services spending is now up 6.4 percent since March of last year. The ongoing transition in spending habits away from goods should allow companies to rebuild inventories (as evidenced by the 2 percent increase in wholesale inventories in May, which included a 1.1 percent increase in retail inventories and a 2.3 percent jump in motor vehicle inventories). The continuing improvement on the supply side should help cool overheated price increases.

Mixed news for manufacturing. The latest Purchasing Manufacturers Index readings released by the Institute for Supply Management showed modest growth in production with a June reading of 53, down from May’s level of 56.1 (readings above 50 indicate expansion). New orders shrank to a level of 49.2 — the first contractionary reading since May 2020. However, manufacturers saw a welcome reduction in input costs, which came in at the lowest level in three months. Inventories hit levels not seen since November of last year. While a contraction in new orders and an uptick in inventories can be a sign of trouble during a normal economic cycle, the abnormally low levels of end-customer inventories (at just 35.2) mitigate that concern. Backlogs were also down as companies hired workers, which alleviated production capacity constraints. The supplier delivery index also fell to the lowest level since July 2000. The combination of increased capacity and slowing orders should lead to further easing of supply constraints and related inflationary pressures.

Consumers flush with cash. The nation’s personal savings rate ticked up modestly to 5.4 percent in May from the prior month’s level of 5.2 percent, according to the latest report from the Bureau of Economic Analysis. Although the rate is down from the 7.9 percent clip during the fourth quarter of 2021, checkable deposits, according to the latest data from the Federal Reserve, remain at a healthy $4.5 trillion for the first quarter. The financial strength enjoyed by consumers can serve as a cushion in the face of current inflation and is part of the reason we believe any potential contraction of the economy would be short-lived.

The week ahead

Tuesday: The U.S. Census Bureau will release the latest readings on May factory orders. Of note in the report will be the latest look at manufacturing backlogs as well as inventory levels.

Wednesday: Investors will get an update on demand for services when the Institute for Supply Management releases its latest data on the sector. We will be watching the report for evidence that the trend toward spending on services continues.  

Friday: The Bureau of Labor Statistics releases the Jobs Report. We will be watching to see if more workers have entered the workforce as we continue to view increased labor participation as an important element in reducing upward wage pressures for businesses.

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