Perspectives - The biggest threat to financial markets: stagflation

The growing risk of stagflation is something we have been talking about quite a lot of late and we revisit it again here, for good reason. At the best of times, stagflation is a central bank’s worst nightmare, as they have to choose between growth and inflation.  However, the current environment makes it even more difficult for a number of reasons.

Firstly, there is often some political pressure to cut rates in a slowing growth environment but, for example, the pressure Trump is currently applying to Powell is unheard of in recent times. Secondly, central banks often fall back on being “data dependent” but the quality of recent data has been notably poor, just look at producer prices in the UK and last week’s US jobs revisions (whilst data sets have been noisy, we don’t think they are politically biased). Thirdly, the tariff pass through remains unclear, with the effective tariff rate fluctuating significantly it’s difficult to assess whether any impact is delayed or simply not coming. Fourthly, in more normal times, fiscal policy might be able to balance monetary policy, for example investing in productivity enhancing infrastructure, but with debt levels high and interest costs increasing in many countries this is less feasible. Finally, in crises over the last few decades, for example, the Global Financial Crisis in 2007/8, policy makers produced a coordinated response. However, recent years have been dominated by a more nationalistic less globalist approach, so that looks less likely too.

Importantly, these are general conditions that certainly compound the issue but don’t impact all countries in the same manner and, of course, countries have very different dynamics to start off with. For example, economic growth is more stagnant in the UK and Germany but growth has been more resilient in the US. Debt piles are high in the US and the UK but much less so in Germany. Furthermore, in the US, looser fiscal policy is on the way, as is deregulation, thereby boosting growth, whilst the US benefits from its position as lender of the last resort.

Indeed, from most angles, the UK comes off looking pretty poor. Looking back at recent history, the Global Financial Crisis hit the UK economy hard, dominated as it is by financial services, and then it was faced with dislocation from Brexit, which of course was pretty UK specific. So, by the time the government decided to lockdown the economy in Covid, things weren’t in the best of shape and the growth and debt position have suffered as a result. Furthermore, the UK’s so called fiscal rules are pretty flaky, in part as they are always forward looking. In contrast, in Germany it’s written into the constitution, though that’s not to say they are never challenged, indeed they were recently. Finally, the UK’s triple lock is particularly punishing fiscally and seemingly untouchable politically.

So, the UK faces high debt levels, stagnating growth and higher inflation relative to most of its peers. Indeed, the UK pain can be seen clearly at a monetary policy level, where the recent MPC vote had to go to a second round for the first time in its 28 year history, as the decision was so finely balanced. Meanwhile, the government’s Autumn budget will be agony on a number of levels as they try to decide who should pay more tax, how much they should pay and how effective it will be in terms of raising tax revenue, whilst not being too damaging for growth.

More generally, it's difficult to know when stagflation will become more of an issue for markets. Clearly inflation is more persistent than many expected and at levels that are uncomfortable for central banks. If this persistency continues then the risk is that inflation expectations become unanchored and second round effects start to grow. From a stagflationary perspective, the longer elevated inflation persists, the more likely it will combine with a recessionary episode or a financial crisis, where pressure for lower rates will increase, therefore forcing the issue.

In summary, there is clear evidence of growing tensions within central banks as they are forced to choose between prioritising growth or inflation. Indeed, the threat to financial markets might well come through the deteriorating credibility of policy makers, while the UK situation is compounded by its delicate fiscal position.  Therefore, looking across the Macro Thematic portfolios, other than some cash-like very short dated gilts in the Defensive Multi Asset fund, there is no exposure to UK government debt. More generally, we maintain our base case of higher for longer inflation and growing stagflationary risk.