In the wake of Credit Suisse’s demise, and the second- and third-largest bank failures in U.S. history, institutional investors are worried—but not just about a banking crisis or a potential recession. The world’s top investors think that the latest financial accidents, which were caused, at least in part, by the Federal Reserve’s rapid interest rate hikes, have made ‘70s-style stagflation an even more dire threat.
The Fed was already fighting to fix the toxic combination of high inflation and low growth with interest rate hikes, but now they must do so in the face of financial instability as well, making any additional interest rate hikes all the more risky. As Billionaire investor Bill Ackman put it in a Tuesday tweet, the banking crisis “remains unresolved” which means “this is not an environment into which the Federal Reserve should be raising rates and adding additional pressure on the system.”
Partly as a result of the roadblocks that the banking crises present for the Fed, some 88% of fund managers said they expect stagflation to continue over the next 12 months in Bank of America’s March Fund Manager Survey, up from 83% last month.
“Investors have never held such strong conviction about the economic outlook,” Bank of America’s analysts wrote of the responses, noting that expectations for economic stagflation have remained above 80% for a record 10 months in a row. Some 244 fund managers with $621 billion in assets under management participated in the survey, which took place during Silicon Valley Bank’s collapse between Mar. 10 and 16.
While 84% of fund managers surveyed by BofA said they believe inflation will fall slightly from current elevated levels over the next 12 months, most also believe a drop back to near the Fed’s 2% target rate isn’t in the cards this year. On top of that, 51% of investors expect weaker economic growth as banking instability continues, setting the stage for stagflation. That’s up from a low of 35% last month, and the highest number since November of last year.
The American public first became aware of stagflation in the ‘70s, when federal deficits boomed due to the Vietnam War and “Great Society” social spending programs meant to fight poverty, exacerbating inflation. Tack on the Arab oil embargo that sent energy prices soaring at the end of the decade, and then Fed Chairman Paul Volcker faced a difficult task in restoring price stability for Americans. The only way he managed to rid the economy of stagflation was through a series of aggressive interest rate hikes that led to a double-dip recession.
Economists have been warning that a similar ‘70s-style stagflation could return for over a year now amid 40-year high inflation rates and meek economic growth. And investors have long believed that “stagflation” is a greater threat to both them and the U.S. economy than a recession for two main reasons. First, the economic phenomenon is typically resolved, as it was under Volcker, by aggressive rate hikes that don’t just cause a normal recession, but a severe one, or multiple recessions. And second, stagflation tends to hold down stock prices.
Morgan Stanley Wealth Management’s CIO Lisa Shalett downgraded her rating for U.S. equities due to “greater chances of stagflation” Monday, citing the Fed’s inability to raise rates to fight inflation following back to back bank collapses.
“Unfortunately, the Fed is boxed in,” she wrote in a note to clients. “While it needs to continue interest rate hikes to combat inflation, which remains stubbornly high, recent events might better be addressed with a pause. The stock market needs to correct to reflect heightened risks.”