Stagflation Mispriced. Allocation And Credit Analysis.

August 5, 2022

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“We’re very likely to get a reduction in nominal spending in the near term….. odds favor a stagflationary environment that could last for years.”
Bridgewater

Tightening Credit = Bad News For U.S. Growth
Hedgeye

Investors are being thrown around between two major concerns. Inflation is too high and growth is too low.

The Bank of England’s statement on Thursday described the problem central banks are confronted with. They announced an accelerated rate hike of 50bp, a near term 13% inflation rate, and a year long recession into 2023.

There are clear problems with their latest action. If inflation is the main problem then interest rates below 2% are unlikely to have any impact on 13% inflation. On the other hand, if the economy is going into a recession then raising rates will make that worse, and already consumer confidence is at an all time low.

What has become clear over the last month is that while central banks have been raising rates to contain inflation, the growth outlook has continued to deteriorate. Of key importance is that credit lending has materially shifted to tightening.

Even before the Bank of England forecasted recession, Hedgeye projected declining growth for the next 4 quarters, through Q2 2023 for the US, and Bridgewater sees something similar…..

Today, our indicators suggest an imminent and significant weakening of real growth and a persistently high level of inflation (with some near-term slowing from a very high level). Combining this with what is discounted, the difference between what is likely to transpire in the near term and what is discounted is the strongest near-term stagflationary signal in 100 years, shown below. 

Data above estimated through June 2022. Estimates based on Bridgewater analysis

Much of Bridgewater’s immediate concerns also stems from what they see in significant changes in credit growth.

The latest work from Richard Duncan, below, shows how the sources of funds for credit have changed going back to the 1960s. Delinking gold from the dollar had a huge impact. Since 1970 savings have declined massively as the main source of credit to 20% from 100%.

The chart also shows the decling support from the Rest Of the World, and it is worth pointing out that the Fed has now reversed support as it has started QT in the last month. This leaves lending institutions by far the main source, so it is not hard to see how tightening of credit from the usual sources would in addition cause a multiple sourced contraction in available credit.

This insight suggests this is an important time to get your allocation right. There is a significant difference between optimal allocation in stagflationary period relative to other environments.

If a stagflation is accompanied by a tightening that drives risk premiums and discount rates up, the impacts are far worse, though the rank ordering of effects across assets is similar. On the other hand, if the policy response favors stimulating to support growth, assets tend to do well for some period of time even in stagflations.
Bridgewater

It is worth also worth pointing out just how elevated the S&P 500 index has become relative to sales growth and GDP growth since 2008 when policy became extraordinarily supportive. If central banks cannot quickly solve the inflation problem, they will be unable to deliver anything close to the prior stimulus.

The chart below shows the dependence of equities on excessive policy support, which took off to record levels from 2008.

It is important to understand the significant risks to US equities from stagflationary developments and credit growth issues.

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