Inflation
Macro and Market
Fixed Income

U.S. Economy Braces for Bout of Stagflation

Lingering inflation and weak growth may mean investors should revisit bond allocations
By Charles Tan,Richard Adams
07/13/2022
Office workers discussing at laptop.

Key Takeaways

We think stagflation is making a comeback after a 50-year hiatus.

Recession risks are mounting due to high inflation and its potential effects on consumer spending and overall growth.

Some investors might consider using bond allocations to hedge a portfolio's inflation risks, with tactical positions in credit- and rate- sensitive securities.

Investors are confronting extraordinary times. This combination of factors stifling economic growth and agitating financial markets is history-making:

  • The world is recovering from the most extensive pandemic in a century.

  • Persistently high inflation rates, last seen in the early 1980s, are crushing U.S. consumers.

  • After unleashing unprecedented monetary aid over the last several years, the Federal Reserve (Fed) is attempting to rein in its massive support.

  • The federal government has accumulated the largest debt-to-gross domestic product (GDP) ratio in U.S. history.

  • Europe is experiencing its largest war since World War II.

  • The lengthy era of globalization is unwinding.

Given this unusual mix of influences, we think advisors should help their clients prepare for three potential economic scenarios over the next several months—stagflation, recession and a growth surprise.

Stagflation

In our view, stagflation — a period of high inflation and weak growth last experienced in the 1970s — is the most likely economic outcome. We expect several factors to keep the inflation rate unusually high, thereby pressuring the growth rate:

  • A supply/demand imbalance in the housing market.

  • The repositioning of global supply chains and onshoring of production.

  • Elevated energy and agricultural prices.

In addition, the Fed is behind the curve after allowing inflation to rise for more than a year before responding. Policymakers face an uphill battle to curb inflation without stalling growth. We believe slowing growth is inevitable.

We expect inflation to peak and gradually subside later this year, but at a much slower pace than most investors expect. We expect long-term inflation to settle at a higher rate than we have been used to.

As stagflation takes hold, we expect the 10-year U.S. Treasury yield to climb higher but with significant volatility as lower growth and high inflation collide. We also believe the two-year Treasury yield will increase as the Fed tightens monetary policy. Meanwhile, credit spreads, particularly in the high-yield sector, likely will widen amid slower economic growth.

What does this mean for investors?

Our Take: Stagflation Is the Most Likely Scenario

Probability of scenario occurring in 2022 is very likely.
Potential Investment Implications
  • Inflation-protected strategies — particularly with short durations — remain attractive as rates rise and inflation remains elevated.

  • Such strategies have tended to offer inflation-adjusted yield advantages and limited credit risk.

  • Higher-quality short-duration strategies may offer benefits if yield outweighs the effects of spread widening. A focus on credit quality will be important, given the pressures on corporate fundamentals from inflation, rising rates and muted growth.

Recession

Although it’s not our base case for 2022, recession risk is rising. Factors that may tip the U.S. economy into recession include:

  • The Fed’s tightening of financial conditions in response to elevated inflation.

  • Slowing consumer spending.

  • A deteriorating global economy.

If recession sets in, Treasury yields and inflation are likely to fall. While inflation in this scenario could moderate more quickly than in a stagflationary environment, we still expect it to remain well above historical levels.

We expect credit spreads to widen more significantly in a recession scenario versus a stagflation backdrop.

What does this mean for investors?

Our Take: Recession Is a Mounting Risk

Probability of scenario occurring in 2022 is somewhat likely.
Potential Investment Implications
  • Diversified strategies with duration exposure may offer performance advantages as rates decline.

  • Inflation strategies still appear attractive, given higher-than-average inflation rates.

  • While credit-sensitive securities may offer income benefits, a more cautious approach is warranted while the economy contracts.

Growth Surprise

While a growth “surprise” is possible, we think it’s the least likely outcome. We see few catalysts for accelerating economic growth. A rapid de-escalation of the Ukraine war could cool energy and food prices, which would help restore consumer confidence.

If growth comes back, we would expect Treasury yields to rise sharply, inflation to climb higher and longer-term inflation expectations to increase. Credit spreads likely would tighten.

What does this mean for investors?

Our Take: Growth Surprise Is the Least Likely Scenario

Probability of scenario occurring in 2022 is least likely.
Potential Investment Implications
  • Credit-sensitive securities may offer potential outperformance, particularly high-yield bonds and bank loans, which have historically tended to benefit during economic expansions.

  • Inflation strategies offer potential advantages as inflation rates continue to climb.

  • Duration strategies may underperform as rates rise.

Bottom Line: Investors Should Consider if Inflation-Protection Strategies Are Appropriate for Them

Our overall view is that high inflation is likely in any economic scenario. Accordingly, we believe the investment environment will look more like the 1970s than the last two decades when low inflation was the norm.

Persistent, higher-than-normal inflation can erode spending power over time. That’s why we believe investors should consider including inflation-protection strategies in fixed-income allocations. We also think they should evaluate whether allocations to interest-rate and credit-sensitive securities may make sense as growth slows or stalls.

With our estimate of recession growing, we believe it’s prudent to increase duration exposure modestly. This strategy may mean sacrificing a little yield today to hedge against a potential recession.

We believe remaining nimble may be the best tactic for exposure to credit-sensitive securities. Given the range of potential economic scenarios, we favor flexible strategies with exposure across credit markets.

Authors
Charles Tan
Charles Tan

Co-Chief Investment Officer Global Fixed Income

Senior Vice President

Richard Adams
Richard Adams

Senior Investment Director

Vice President

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Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

Diversification does not assure a profit nor does it protect against loss of principal.