In our third and final post of the day discussing stagflation (here are part one and part two), we look squarely at the reason why Wall Street is finally freaking out about the threat of rising inflation in a time of shrinking growth or outright contraction (for Wall Street's definition of stagflation or rather lack thereof, see here) by taking a look at how markets perform during periods of stagflation. Spoiler alert: it's ugly.
As Goldman's chief US equity strategist David Kostin writes in his Weekly Kickstart, “Stagflation was the most common word in client conversations this week as equity market volatility remained elevated." One look at interest rates and energy prices should explain why.
There is a reason why Goldman clients are worried: while Kostin repeats that "stagflation is not our economists’ base case expectation" even as his economics team just cut its GDP forecast again while hiking its inflation outlook, he admits that "the weak historical performance of equities in stagflationary environments helps explain why investors are concerned."
How weak? Well, during the last 60 years, Goldman calculates that the S&P 500 has generated a median real total return of +2.5% per quarter, but that quarterly return fell to -2.1% in stagflationary environments, worse than the median returns in environments characterized solely by weak economic growth or high inflation.
Of course, one would have to look far and wide to find a trader who was actually active during the last major stagflationary episode, or even during the somewhat milder ones at the start of the century, and is why Kostin notes that "US equity investors have had little experience with stagflation in recent decades" which have been characterized mostly by deflation.
By way of background, Kostin defines "stagflationary periods" - a term which as the recent Deutsche Bank poll found there was a wide disparity of opinions as to what exactly is "stagflation" - as episodes of two or more consecutive quarters in which core CPI inflation ran at least 50 basis points above the consensus long long-term expectation while real US GDP growth registered 50 bp or more below trend.
As the next chart shows, since 1960, 41 quarters (17%) have met these criteria, but the vast majority of those occurred between the late 1960s and early 1980s. In the 21st century, stagflation has been virtually non-existant, until now.
It should hardly come as a surprise that most of the equity market weakness in historical stagflationary environments has been attributable to pressure on corporate profit margins. That's because stagflation has been associated with stable real revenues but declining profit margins and real earnings, indicating companies struggling to raise prices quickly enough to offset rising input costs.
In addition to the earnings headwinds, Godlman also notes that P/E multiples have also declined modestly during stagflationary periods alongside rising interest rates.
Who are the winners and losers during stagflation?
At the sector level, Energy and Health Care have typically generated the strongest returns during periods of stagflation. That may explain why during the past month, Energy has been the strongest sector in the market, rising by 14% alongside an equivalent surge in crude oil, yet Health Care has declined by 6% and lagged the S&P 500 (-3%). This split outcome hint at dynamics that are more consistent with a market pricing rising growth and inflation than one focused on the type of economic growth weakness that would characterize a stagflationary environment.
And while Goldman purposefully ignores the "other" possibility, it may also indicate that the market is woefully mispricing stagflation risks, as DB's Jim Reid suggested earlier. In light of Goldman's increasingly more frequent downgrades of US GDP, it is this alternative that looks far more realistic to us.
In any case, looking at the big stagflation losers Goldman notes that "Industrials and Information Technology have generally lagged most during stagflationary environments. The Info Tech sector is less cyclical now than it was during the stagflationary years of the late 1960s to early 1980s due to the compositional shift toward software and services firms." Today, however, the sector’s massive long long-term growth profile has given it a longer “duration” than most other equities, making it particularly sensitive to real interest rates.
Further to this point, Albert Edwards showed last week that global tech stocks have become "cojoined" been with the US 30y bond yield since the start of this year. The SocGen strategist noted that "if the US 30y yield rises to 2.4% from the current 2.1%, it would knock some 15% off tech stock prices. Imagine if the US 10y rose from 1.5% currently to 2¼%! We could see quite a bear market in tech!"
Going back to Kostin, not even this perennial optimist can deny that the sector would likely still be vulnerable to stagflation today if such an environment led investors to price higher future interest rates to combat inflation.
Goldman then looks at the thematic shifts that have emerged during stagflationary periods, and notes that stagflation has been associated with shifts in consumer spending behavior and the outperformance of services companies relative to firms selling goods. Value and Size factors have generated roughly the same median returns during stagflationary periods as they have in general during the last 60 years. However, during stagflationary environments, real personal consumption expenditures for goods have grown at a median annualized rate of 1% compared with 3% for services. To justify this point Goldman looks at the historical performance of consumer stocks which reflects this gap: "Consumer services industries like restaurants and entertainment have outperformed goods industries including apparel and retail by over 100 bp per quarter during stagflationary periods compared with roughly equivalent performance in all periods." The coming stagflation likely explains why consumer goods companies have lagged the S&P 500 since May, while consumer services firms have traded with the shifting virus outlook (see Exhibit 4).
Another reason why stagflation has pernicious and adverse side-effects on all aspects of life is that historically it has weighed on not just economic growth but also the growth of household wealth. Household net worth has grown by a median real rate of 0.5% per quarter since 1960, but just a 0% rate during periods of stagflation. These periods have also been associated with declining household allocations to equities, helping explain the weakness in equity valuation multiples. Home prices have typically declined in real terms during stagflation while gold has appreciated.
And yet, despite these admissions that stagflation has all but arrived, Goldman falls back on the tired, cliched narrative that "inflation is transitory" and the bank - which has a 4700 S&P price target, expects "equity market will continue to rally." Goldman also falls back on the ironclad bullish defense that every dip has been bought so far, and the current one will too, because why not:
... we believe this dip will prove a good buying opportunity, as 5% pullbacks usually have in the past. The 226 trading day stretch between last November and last Thursday ranked as the 8 8th longest period since 1930 without a 5% S&P 500 pullback. Since 1980, an investor buying the S&P 500 down 5% from its 12 12-month high would have gained a median of 6% during the subsequent three months and enjoyed a positive return in 82% of episodes (28 of 34). Our year year-end S&P 500 target of 4700 reflects 7% upside from today’s price.
Its traditionally oblivious optimism aside, Goldman notes that Q3 earnings reporting season begins next week, and investors will be paying close attention to corporate messaging regarding the path of profit margins.
Last quarter companies expressed an unprecedented degree of attention on input costs and price hikes, and we expect margins will remain the primary focus of both investors and managements this quarter.
Curiously, at this point a major schism has opened up between Goldman's traditionally bullish take and Morgan Stanley's increasingly bearish outlook, and as the bank's equity strategist Michael Wilson wrote last week when he predicted that a "fire and ice" scenario is coming that will send stocks sliding more than 10% in the coming days, a large number of companies are flagging serious supply chain issues in off-cycle earnings reports suggests and "both forward earnings estimates and price de-rated after many of these reports."
Jumping to the punchline, Wilson thinks this will be a pervasive dynamic during 3Q reporting season and it will "trigger downside in earnings revisions at the index level - a headwind for price."
Which begs the question: who will be right on the outcome of Q3 earnings season, and whose year-end price target will be closer to the S&P500 on Dec 31: Goldman with 4,700 or Morgan Stanley at 4,000.