Powell wants to bring rates closer to neutral.  But what is it ?  Think 5% to 6%, says former top Fed official

The stock market is starting to price in the “growing risk of stagflation”, says the CEO of Research Affiliates. Here’s how investors can position themselves.

Stock markets are beginning to price in “the growing risk of stagflation,” according to Chris Brightman, managing director of Research Affiliates.

“Investors are repositioning their portfolios to protect the real value of their financial capital,” Brightman wrote in a Research Affiliates note this month. “Capital markets have panicked as investors try to anticipate how soon the Fed will be able to bring inflation back to its target” and whether the Federal Reserve’s monetary policy tightening will lead to a recession, he said in the note.

Stocks and bonds have sold off this year amid the highest cost of living in about four decades and slowing economic growth. Brightman, who is also chief investment officer at Research Affiliates, sees a “more than one in three chance” of stagflation, a scenario in which the United States could end up struggling with both high inflation and a recession.

“If the Fed fails to get inflation under control and we have a recession or two, expect capital markets to behave like they did in the late 1970s and early 1980s,” he said. Brightman. “Interest rates will skyrocket towards or above the current rate of inflation,” he said, while “equity prices will fall” as price-earnings multiples contract.

To see: ‘You don’t want to own bonds and stocks’ in this environment: Paul Tudor Jones

Today, the cyclically-adjusted price-to-earnings ratio known as Shiller’s CAPE is well over 30, according to Brightman’s note. During the last period of stagflation, “Shiller’s CAPE fell below 10 in 1977, bottomed out at 7 in 1982, and failed to recover above 10 until 1985”.

Based on the current state of the price/earnings multiple, “a drop to even 10 implies an appalling drop in stock prices,” Brightman wrote.

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US inflation as measured by the consumer price index climbed at a rate of 8.5% in the 12 months to March. “How can a 3% fed funds rate tame the 8% CPI?” Brightman said. “I see at least an even chance that the Fed will fail to get inflation under control quickly.” He also estimated “at least an equal chance” for a recession before the end of next year.

Under the threat of stagflation, investors “can reduce exposure to equity beta and nominal duration by selling conventional stocks and bonds in favor of commodities and real assets, the prices of which have historically risen in response rising inflation,” according to the Research Affiliates note.

“Investors can protect the real value of their principal bond by swapping nominal bonds for TIPS,” or Treasury inflation-protected securities, Brightman said. And, “as recent stock price movements show, investors will flee longer-duration growth stocks and look to shorter-duration, exceptionally cheap value stocks in their equity portfolios.”

The U.S. stock market was choppy on Tuesday but ended higher, the day before Fed Chairman Jerome Powell’s press conference following the central bank’s two-day policy meeting on Wednesday.

Also see: Will the Fed rate hike be a “compensating event” for the struggling US stock market? What investors expect on Wednesday

All three major US stock indices have been beaten this year, with the S&P 500 SPX,
+0.48%
down 12.4%, the Dow Jones Industrial Average DJIA,
+0.20%
down 8.8% and the technology-heavy Nasdaq Composite COMP,
+0.22%
19.7% drop, according to FactSet data.

Citigroup analysts said in a research report dated April 29 that “global stock markets are moving toward three themes of stagflation – high inflation, rising rates, weak growth.”

They suggested a global equity strategy to hedge against these three themes. “These are long commodity stocks, long defensive stocks and short (real) rate-sensitive growth stocks,” the Citi analysts wrote. “Investors fearing a crash in commodity prices should look to financials.”

Citi’s stagflation portfolio has benefited from an “overweight” to commodity-exposed sectors and the market, but the bank’s strategists are “bearish on oil, citing the prospect of weaker demand and a increased supply,” according to the report.

Additionally, weak China’s economy could “put pressure on metal prices,” Citi analysts wrote. So, “Commodity stocks are probably the first part of the stagflation portfolio that we would drop.”

In an April report from Ray Dalio’s hedge fund firm Bridgewater Associates, co-chief investment officers Dalio, Bob Prince and Greg Jensen warned that “stagflation is the big risk and the war in Ukraine has added to that. “. The war has amplified “pre-existing pressures,” with the biggest impacts on commodity markets where Russia is a major supplier, they wrote.

“The Fed and other central bankers face a difficult political dilemma with a set of uncertainties and risks as great as any since the 1970s,” Bridgewater’s co-CIOs said.

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