Inflationary Risk Smoke Signals: What Could Be Ahead

Apr 22, 2022

Regular Money Talks readers know I believe inflation will likely remain elevated for the foreseeable future.

However, the relationship between inflation and the economy isn’t necessarily as clear-cut as many folks assume.

According to the conventional wisdom, periods of high inflation tend to result in a booming or overheated economy and a strong job market (or vice versa). On the other hand, periods of low inflation or outright deflation tend to coincide with a weak economy and higher unemployment.

Even the Federal Reserve’s official mandate – to find a balance between stable prices (low inflation) and full employment by moving interest rates up and down – is heavily based on this idea.

However, we only need to look back to the 1970s to see that this isn’t always how it works. Back then, we saw years of high inflation alongside persistent economic weakness.

This combination came to be known as “stagflation” – as in economic “stagnation” plus “inflation” – and it baffled economists who didn’t believe it could happen at the time.

Ultimately, the Federal Reserve had to choose to prioritize one of its goals at the expense of the other.

As you may know, it chose to fight inflation. It raised short-term interest rates from below 5% to a peak of nearly 20%.

This effort did “break the back” of inflation, but it also pushed an already weak economy into a severe recession. Unemployment soared to more than 10% at its worst.

Unfortunately, I believe we could be headed into a similar situation today.

The U.S. government’s official inflation gauges show that prices have been rising at the fastest pace in decades over the past few months. Yet instead of seeing signs of an overheating economy, we’ve recently started to see signs of potential weakness.

For example, there has been a significant reversal in several housing market indicators in the past few weeks.

Positive indicators like online “homes for sale” searches, touring activity, and mortgage applications have been dropping, while negative indicators like new home buyer cancellations and listing price cuts have risen.

Meanwhile, mortgage rates have been soaring. The average rate on a 30-year fixed-rate mortgage rose to more than 5% this week. It was just over 3% in January – an increase of more than 60% in less than four months.

We see similar signs of weakness in the credit markets.

Both government and corporate bonds have been plunging as long-term interest rates rise.

We’ve already seen some parts of the yield curve invert, where shorter-term interest rates trade above longer-term rates. These inversions have a near-perfect track record of predicting recessions between a few months and a couple of years in advance.

And delinquencies have been rising sharply in riskier consumer debt, including subprime auto loans and credit cards. This is often an early sign of a slowdown in consumer spending, which accounts for a huge portion of economic activity.

Finally, we’ve also seen signs of a significant slowdown in the transportation sector – including trucking and rail freight volumes – for the first time since 2020.

What’s most concerning about these signs is that they’ve been occurring before the Federal Reserve has started tightening monetary policy in any meaningful way.

The Fed has increased short-term interest rates by just 0.25 percentage point so far. And it hasn’t even started to unwind its massive quantitative easing (QE) bond-buying program.

In other words, these signals suggest the economy is already moving toward a stagflationary environment. If the Fed follows through with its plan to aggressively fight inflation, a severe recession could be unavoidable.

Now, let me be clear…

I’m not predicting that a recession is coming in the next few months. I’m not even predicting that a recession is guaranteed at all.

I’m simply pointing out that the risk of an inflationary recession is rising. So I think it now makes sense to take some extra precautions with your investments to protect yourself from that risk.

Fortunately, as a Money Talks reader, you are already better positioned than most investors.

That’s because the inflation-investing guidelines I shared with you last month generally apply in a stagflationary market environment as well.

However, I would suggest a few simple additions to reduce your risk further in the case of a recession.

Next week, I’ll explain these additions in more detail, and share an example of a risk-balanced, “stagflation-proof” portfolio I’ve built using our TradeSmith tools.

In the meantime, if you have any questions or comments on what we’ve covered so far – or any previous Money Talks topics – you can always reach me directly at [email protected]. I can’t respond to every email, but I read them all.

All the best,

Keith