Why Investors Should Brace for ‘Stagflation’

Recent stress in the banking sector has unequivocally complicated the U.S. Federal Reserve’s mission of fighting inflation. It has also made an economic recession much more likely.

U.S. stock investors, however, seem to be shrugging off such risks. Following regional bank failures earlier this month, fixed income investors rushed to the perceived safety of U.S. government bonds, driving up their prices. Yields on U.S. Treasuries, which move inversely to their prices, saw jaw-dropping declines as traders began anticipating an earlier pause in Fed rate hikes; the 2-year yield, for example, dropped more than 100 basis points from a recent high of 5.07% earlier this month, amid concerns about the economy’s prospects.

Stocks, meanwhile, continued trading in a relatively narrow range, despite the obvious risks that banking stress poses to the economy. What seemed to matter to stock investors was the potential for a dovish Fed pivot that might spark a new bull market.

We think investors should think about the broader economic outlook rather than what might boost equities. Today’s stock-market resilience ignores mounting risks of a hard economic landing, weakening corporate profitability and “stagflation”—when inflation remains high, the economy slows and unemployment rises. Here are three reasons why this scenario seems increasingly likely:

• Banking industry turmoil will likely lead to tighter lending standards and financial conditions. Regional banks with less than $250 billion in assets account for a significant percentage of loans made in the U.S.—about 50% of all commercial and industrial (C&I) loans, 70% of commercial real estate loans and 38% of residential mortgages. If struggling regional banks tighten the growth of C&I loans, in particular, growth in U.S. gross domestic product (GDP) could slow, since C&I loans directly affect company viability, employment and, thus, consumption. To put it another way, when C&I loan growth slows, unemployment is apt to rise. Recent tightening of lending standards suggests the unemployment rate could increase by 2.5 percentage points in the next one or two years. 

• Regional banks’ overall profitability is likely to come under pressure, which could put further stress on the economy. Banks could see increasing competition for customer deposits from higher-yielding Treasuries, certificates of deposit (CDs) and money market funds. To retain deposits, banks will likely need to increase the interest rates they pay depositors, which could squeeze bank profit margins. In addition, credit-rating agencies have recently cut their views of the banking system, which only exacerbates such margin pressures.

• Concerns about financial stability could force the Fed to drop its inflation-fighting efforts prematurely. Price pressures remain relatively high, with the core consumer price index (CPI) rising 5.5% year-over-year in February and services inflation still accelerating. The risk is that inflation stays higher for longer, even as the economy slows—a recipe for stagflation that would likely see consumers suffer a decline in spending power once their incomes are adjusted for inflation.

Although the turmoil in the banking sector may indeed presage a sooner-than-expected pause by the Fed, equity investors need to acknowledge the growing risks to the economy rather than see this potential policy shift as a signal to buy into the market. These risks are not currently factored into consensus estimates for 2023-2024 corporate earnings or stock valuations.

The right course for investors: Pay attention to economic data, including inflation and unemployment. And stay patient, with solid portfolio exposure to yields and income. We are focused on cash, short-duration bonds and dividend growers. Global dividend stocks could add diversification.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 27, 2023, “Mission Disrupted.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.