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  1. Home
  2. / Investing
  3. / Stocks

Don't Underestimate the Power of Stagflation

The Fed might be proven right that inflation is 'transitory,' but after how much damage? Let's get out our Econ 101 books and review.
By MALEEHA BENGALI
Oct 18, 2021 | 12:16 PM EDT

By now, the highest word count on any search engine should be for one term: stagflation.

Most who do not know what the word means -- or who needed to brush up on their old economics textbooks -- must be up to speed by now. It is a very powerful phenomenon, and not well understood, as it has not been witnessed by this generation of traders.

The debate is not whether inflation is evident -- most are wondering how to quantify the phrase "transitory" that the Fed keeps using. It could mean one month or perhaps as long as a year. Eventually inflation can prove to be transitory, but only after it causes a severe shock to the system when the system cannot handle the stress anymore and causes demand or growth to collapse and prices to fall. At that rate, the Fed may be proven right as after the cycle, inflation may be transitory, but after what extent of damage?

There seems to be a few discrepancies as to the way various asset classes are interpreting the economic cycle right now. Bonds (as much as they are allowed to, given the Fed influence) and rates/break-evens are clearly showing inflation stress. The dollar, too, is trying to break its key $94.50 level on the dollar index, the DXY. Given the shortage in gas and coal and the subsequent rally in those commodities, for good reason as these commodities are micro, they rely solely on demand vs. supply balances. Investors are allocating money into commodities in general, which feeds into all the instruments. But one needs to be careful which ones they choose, as this phenomenon can have different implications for ones exposed to the cyclical nature of the economy.

Copper is a good one that comes to mind. China released its third quarter gross domestic product data on Monday, showing it grew by 4.9% year-over-year vs. the 5% expected growth, and precious number of 7.9%. It also missed on its fixed asset investment and industrial output numbers. The former grew at 7.3% year-over-year in September vs. the previous number of 8.9%. The latter came in at 3.1% year-over-year in September vs. 5.3% previously. This just shows the rate of change is much lower from the highs of this year. As the COVID-induced stimulus has now run out across the board, we have yet to see what the global Purchasing Managers' Index will flash this Friday. We know the macro surprise indexes are pointing lower, given the surge in raw material prices and input costs, as businesses are seeing demand destruction -- which is very evident in fertilizers and auto manufacturers. All this is synonymous with slower GDP growth to come. After all, going back to Econ 101, the only thing that can contain inflation is prices spiking to a level where demand shuts down. That is where we are now.

On the one hand the market is blindly chasing the "buy any hard asset" narrative, because there is inflation -- but without necessarily looking at each commodity's demand supply balances. It is always easy to assume past demand trends and extrapolate them into the future, assuming no change, but that rarely ever happens. Supply side is the easier one to predict. But make no mistake, when demand does ease and inventories rise, sell-side houses will be ready to take their numbers down after prices fall 20%-30%, of course. So, when one gets tons of research upgrades on Commodities with "tight" demand vs. supply, it is important to brush out your own models and old econ books. If demand slows then surely all economically geared commodities should start to fall, too.

The irony of the story is that the true real inflation hedges like gold and silver have not budged at all. They remain stuck in their doldrums, despite market-chasing the inflation narrative. Flows can distort assets only so far until the elastic band snaps. Be ready for that, and don't be the last one caught holding it, especially when the fundamentals are pointing in the other direction.

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At the time of publication, Bengali has no position in any security mentioned.

TAGS: Commodities | Interest Rates | Investing | Stocks | Oil Equipment/Services

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