Whither Stagflation? An Interview with Adrian Cronje, Ph.D.
A quick search on Google Trends confirms what the economic headlines suggest: “stagflation” is all the rage. But as with many unfamiliar economic/business terms, how well do people know that which they seek to define? In addition, once defined, how do they wish to use it? In a time where unprecedented access to information allows any individual to become an “expert” in epidemiology during a pandemic, international relations during a war on foreign soil, or macroeconomics and monetary policy during a period of high inflation, we feel it crucial to bring in a true macroeconomic expert to help us understand stagflation. So, we are here with Adrian Cronje, CEO and CIO of Balentine. When Adrian is not stewarding the company and the investment team, he is delving into his passion as an economist. Honing his craft at the University of Cambridge, Adrian developed a deep knowledge of the teachings of predecessor John Maynard Keynes, economist par excellence, whose impact on 20th-century economics may be unmatched.
Investment Strategy Team: Adrian, thank you for taking time out of your day-to-day duties to discuss stagflation, a very popular topic at this time.
Adrian Cronje, Ph.D., CFA: I’m happy to be here. I am in complete agreement that it is crucial for us all to better understand current market dynamics. Capital markets lead the economy, not the other way around. They are the lens through which the future economic environment should be viewed. On the other hand, relying on economists to forecast future outcomes is akin to driving your car down the road by looking in the rearview mirror. Economists are good at telling you what is happening in the moment, or where the economy has come from, not what will happen in the future.
Investment Team: Let’s start with the obvious fundamental question: what exactly is stagflation?
Adrian Cronje: Stagflation is an economic condition characterized by low growth and high inflation. The word is a combination of “stagnation” and “inflation,” where “stagnation” is defined as meager or negative economic growth.
Investment Team: Doesn’t standard macroeconomics dictate that such a scenario is not possible? After all, if prices are rising, then demand is generally outpacing supply. If low growth and high inflation exist simultaneously, how can it be that output is growing slowly or even falling?
Adrian Cronje: That is generally correct, assuming the economy is functioning normally. Unfortunately, right now we are dealing with severe supply shocks that are driving the economy to function sub-optimally.
Investment Team: A year ago, inflation was running at 2.6% and real GDP was above pre-COVID highs. Now, a year later, inflation is running at more than 8% and there are concerns that the Federal Reserve may have to raise interest rates so aggressively, to keep inflation expectations in check, that a recession may ensue. How did we get here?
Adrian Cronje: As we discussed in our 2019 Capital Markets Forecast, over time the economy deviates around a trendline as a function of the strength of economic activity, which we can measure in output and price level. When the economy deviates far enough above its trendline, growth becomes unsustainable, and an economic contraction known as a recession occurs, resulting in falling prices and higher levels of unemployment. If the deviation is not merely large but rather substantially so, then it creates a particularly nasty recession, as we saw in 2008-2009. In the most egregious of cases, a deviation can cause a depression, as we saw in the U.S. starting in 1929.
Policymakers try to minimize these negative fluctuations by keeping the economy as close as possible to that underlying trend rate of growth using the tools of monetary and fiscal policy. The Federal Reserve (Fed) sets interest rates by targeting “full employment” and “stable prices”: a dual mandate set for them by Congress. As the economist John Maynard Keynes outlined in the 1930s, fiscal policy can provide powerful impetus to return an economy to its trendline if a fiscal stimulus in the form of government spending or tax cuts is implemented in a timely, targeted, and temporary way.
Unlike their response to the 2008 Global Financial Crisis, when monetary and fiscal policy were often at odds with each other, the Fed and Treasury worked in concert as the economy fell short of its potential during the COVID lockdown of 2020. The fiscal stimulus was timely and targeted as the Fed flooded the markets with money against a backdrop of ultra-low interest rates and balance sheet expansion; the question now is whether it was sufficiently temporary. Many economists calculate that the fiscal stimulus may have overstimulated the economy, arguing that an unsustainable surge in consumer demand and economic growth pushed the economy above its underlying trend rate of growth.
In addition, other contributors to current supply shocks include renewed lockdowns in COVID-plagued China, the epicenter of many supply chains and the war on Ukraine.
Investment Team: It’s really amazing. Two years ago, around this time, at the onset of the pandemic, we were concerned about an economic depression and mass deflation. A year later, we seemed to be dealing with a Goldilocks economy, and now another year later, we are up against an inflation storm. Boy, things move quickly.
Adrian Cronje: Yes, many are now questioning whether the economy will return to a more sustainable underlying trend rate of growth and whether the Fed will increase interest rates to bring demand and constrained supply back into balance without causing a recession.
In my view, an important influence on the outcome of the Fed’s efforts, which does not get enough attention, is the possibility that the economy’s underlying trend rate of growth has been boosted by rising productivity growth.
High rates of productivity growth, such as those seen in the 1920s, 1950s, and late 1990s increase the underlying trend rate of growth for the economy – the natural speed limit for the economy where growth and inflation is in balance. It allows companies to do more with less and to continue to make profits even of their cost of capital increases as interest rates rise. Today, the seeds of higher productivity growth may have been planted by the “reacceleration” we saw in the aftermath of the pandemic, when companies were forced to do more with less. Examples of sources of productivity growth could include virtual communication, increased automation, and the broader adoption of artificial intelligence and the blockchain protocol. This would be analogous to the benefits the economy experienced in the “roaring 1920s” from the invention of electricity, automobiles, and aviation, and in the 1990s from the proliferation of the internet.
So, the key to the Fed correcting policy without causing a recession is affecting a decline in demand, easing supply chain disruptions, and increasing the potential for productivity growth. It is worth keeping a sharp eye on this.
Investment Team: Let’s talk further about the supply shocks we are experiencing – a situation that policymakers cannot affect directly. On top of the abundant monetary and fiscal barrage you referenced, we are now facing supply problems. What started out as supply chain disruptions from the pandemic have now perhaps morphed into structural supply shortages in oil and agriculture commodities. How does this play into our near-term future?
Adrian Cronje: In last March’s blog discussing the ins and outs of inflation, we described two types of inflation: Demand-pull inflation results from high aggregate demand and results in economic strength. Cost-push inflation results from low aggregate supply and causes economic turmoil. Though they both cause high inflation, their remedies differ because they are generated differently – so what solution exists to resolve both types of inflation when they exist simultaneously?
There are two options to reduce inflation: decrease demand or increase supply.
Some argue that reducing rates will beget increased supply as companies take advantage of cheaper capital costs to invest in additional supply-generating capacity. However, in such a scenario, demand is likely to increase even more than supply, leading to further price increases. So that is not likely to be effective.
In any case, the Fed is not in a position to increase supply. Of sharply rising gas prices in 2011, Ben Bernanke famously said, “There’s not much the Federal Reserve can do about gas prices, per se, at least not without derailing growth entirely, which is certainly not the right way to go. After all, the Fed can’t create more oil. What we can do is basically try to keep higher gas prices from passing into other prices and wages throughout the economy and creating a broader inflation, which would be much more difficult to extinguish.”
So, the Fed is left with one remedy, if desired: reduce demand. While this would tame some of the inflation, I am skeptical it will be the panacea the Fed is seeking, as supply constraints will continue to exist, which, as mentioned, are beyond their locus of control.
Investment Team: Are there any historical equivalents from which to draw lesson?
Adrian Cronje: The 1970s is the only period since the 1800s that had both high inflation and weak growth. Fed Chairman Arthur Burns was originally loath to fight the inflation, as he had seen his predecessor removed from his position for attempting to dampen growth too much. He was forced to act when inflation began to accelerate in 1973 amidst the Arab oil embargo. His options were limited: the Fed could only raise rates so much without destroying growth to a level that people would not tolerate, and Congress would not adjust fiscal policy. As a result, Burns raised rates until he was unwilling to do so any further. As inflationary pressures persisted, he continued to push back on the fiscal spending to no avail. He was replaced by William Miller, who faced the same dilemma. Even worse, Miller had to deal with declining growth at the end of Burns’ period. So, he loosened things a bit to get growth up, and inflation went wild. After years of rampant inflation, Paul Volcker stepped into the fray and made the hard choice to sharply raise interest rates, causing a very severe recession to quell the inflation.
Investment Team: So, which “flation” will we experience?
Adrian Cronje: Today, we see a supply shock in the energy and commodities space, similar to what we saw in the 1970s, which is driving cost-push inflation and the U.S. labor market is already showing signs of overheating, so the Fed must act.
The Fed will likely utilize two tools: interest rate policy and the size and composition of the balance sheet. In other words, the hope is that raising rates modestly and lowering the balance sheet in tandem should accomplish today what required large rate hikes and a severe recession in the 1970s.
Of these tools, interest rate policy has a greater effect on Main Street (the economy) than Wall Street (asset prices), as mortgages, auto, and student loans become more expensive. Right-sizing the balance sheet will likely have a larger effect on Wall Street than Main Street. It will be interesting to watch how the Fed balances the two levers and spreads the burden of adjustment on Main Street or Wall Street.
There are three possible outcomes as this unfolds, each one showing a tradeoff between growth rate and inflation rate:
- Continued solid nominal growth with high inflation,
- Lower nominal growth with modest inflation, and
- Negative nominal growth (a recession) with disinflation or deflation.
Scenario 1 is really no longer on the table given the Fed’s explicit intent on taming inflation, something to which even the most dovish of members have alluded, of late.
Of the two remaining possibilities, the stagflation of scenario 2 is more likely than the contraction of scenario 3. To achieve scenario 2, demand must be stifled in enough magnitude to decrease growth without pushing growth negative.
Again, scenario 2 does not necessarily mean recession. As much as the 1970s are put forth as the model of a weak economy with inflation, real growth during the period was 2.4% – not great, but not awful either. In fact, such growth is better than that which was experienced during more than half of the 2010s, a decade that strikes people as solid.
More likely, higher energy prices and food costs will put a dent in real GDP growth. There is a template for this in history: although the energy sector will see increased earnings, GDP weakness in other sectors will more than offset it, creating a net negative.
Scenario 3 is unfortunately a possibility if the Fed gets as aggressive in its tightening as it was in its easing. Such a scenario would certainly wring out inflation from the system, but at what cost? The goal here is to reduce growth but certainly not hammer it. Much of this will depend on how much the Fed relies on balance sheet reduction in lieu of more extreme interest rate hikes, to which we alluded earlier.
To be fair, there is a fourth possible scenario: a “soft landing”, where growth stays above par, but slows, while inflation comes down to a palatable level. As I said earlier, policymakers will need some help to engineer this outcome with supply shocks easing and productivity growth riding to the rescue.
Investment Team: How are capital markets seeing things?
Adrian Cronje: Remember that capital markets typically move in advance of the economy, as they sniff out looming changes in the economic dynamic.
In the bond market, the yield curve has inverted over some durations. 5-year yields are currently the highest in the curve, and there was a brief inversion between the 2-year and 10-year treasury yields. Inversions mean the market believes Fed policy has erred or is going to err. Inverted yield curves are always to be heeded, so an inversion in the spread between 2-year and 10-yields tells us the mistake has yet to occur but is coming if the Fed is not careful. Because the yield curve is currently upward sloping at the short end of the curve, any economic concern destined to occur is likely not in the next 12 months, assuming no further external shocks. So, while the good news is that the pain is less likely to occur in 2022 than 2023, make no mistake that the bond market is sniffing out potential danger.
In the equity market, the tone of leading asset classes has taken on a more defensive feel. Of course, we continue to see strength in the energy sector on the strength in oil prices, but there is more to it than just that. In 2021, banks outperformed and utilities underperformed as rates rose. Now as rates rise, we are seeing the opposite, which is counterintuitive: banks excel as rates rise while utilities, often viewed as stable fixed income substitutes, generally weaken as rates rise. This comes down to what we communicated in the second part of our inflation blog last year. When rates are rising and inflation is reversing pernicious deflation, thus signaling expansion, the market loves it. When deflation has reversed and inflation is beginning to eat into corporate profit margins and real personal disposable income, concerns about economic stress surface. We believe this is the message of the recent bank underperformance and utilities outperformance despite the rising rates.
Investment Team: How does all of this inform your investment allocations?
Adrian Cronje: Despite the leadership changes we are seeing in asset classes, the equity market has been dealing relatively well with many of the ongoing global disruptions, with the S&P ending March only 6% off the January 4 high. But now the equity market has to deal with the potential “disruption of all disruptions”: with rates increases on the horizon, the Federal Reserve will no longer be an ally. This is not to suggest this is a permanent dynamic, but there is no doubt the Fed may be content with a market correction serving as a de facto tightening tool for them. The notorious “Fed put” (where the Fed has tended to try to offset any correction) is likely gone for a while.
Does this mean market catastrophe? Our models are telling us that this unlikely given what we know today. There have been years of rising interest rates that did not result in secular bear markets. Notably 1994 and 2013 come to mind, the former of which was a flat year for stocks and the latter of which was a stellar year for stocks. And, like 1994, today we find ourselves 14 years into a secular bull market with an aggressive Fed trying to cool things two years after a recession.
Yet even as we pound the table that the secular bull market should not be threatened here, we continue to affirm what we have been suggesting this year: bumpiness and some stress make for a “fasten seat belt sign.” 2022 will likely remain a market where we digest the relatively easy gains over the last two years and chop around while things consolidate and take a breather, at least leading into the November midterms. While not the most fun in the short-term, it will set up the market for success over the longer-term.
Having said all that, we remain vigilant in looking at the market through the lens of relative valuation, a key component to our model discipline when comparing the outlooks for risk assets. Even as stocks chop around, it remains possible that they could become extremely expensive relative to bonds if bonds cheapen during that time via rising bond yields and/or additional yield curve inversion. Under such a scenario, our models will call for us to reduce our stock allocation. Our models suggest this is not imminent and, thus, is not our base case. However, if circumstances change, thereby indicating the increasing likelihood of a more pernicious outcome, then we would not hesitate to make a policy change due to our emphasis on capital preservation. Meanwhile, within equities, we remain positioned in the areas that are best served to benefit in an inflationary or stagflationary environment while lessening our allocation to areas most likely to be damaged in such an environment: our portfolios are anchored by US Value stocks with an emphasis on the Energy sector.
Investment Team: That is all very helpful. Thank you for your time.
Adrian Cronje: Thank you.
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