Is the prevalence of high inflation and low growth overblown?

Stagflation risk is on many investors’ minds but there are compelling arguments why buying opportunities may emerge.

Shares First Republic Bank dived after the company's earnings report showed its clients withdrew more than 40 per cent of deposits. Picture: Getty Images

Stagflation risk was a pervasive theme at the Alpha Live investment conference in Sydney but there were also some compelling arguments as to why good buying opportunities may be emerging.

Inflation has peaked but is still excessively high and growth continues to be strong as the economic effect of aggressive rate rises over the past year is only just starting to be felt.

But how central banks will react if the current boom-like mix of high growth plus high inflation gives way to a toxic mix of low growth and high inflation – in the context of elevated public debt after the Covid-19 spending binge – is now a key uncertainty for global markets.

Crude oil has fallen back to levels seen before the shock OPEC+ supply cut and most regional Fed surveys fell last month, suggesting that recession risk is building, even as services are strong.

But whether in terms of volatility or cyclically adjusted valuation – albeit driven by mega-cap tech stocks – the US sharemarket appears to be assuming inflation will return to target before too long, the Fed will stop increasing and recession will be avoided, even though the real Fed funds rate remains negative.

There’s no doubt that inflation has peaked, as goods price growth has fallen rapidly in response to the post-Covid normalisation of supply chains, but services inflation is rising sharply.

However, rather than sacrifice growth and employment in the event that inflation stays high and growth falters, central banks may become more tolerant of above-target inflation.

Of course a reacceleration would be a nightmare scenario for central banks and markets.

First Republic Bank fell 80 per cent in two days, after revealing it suffered a $US100bn deposit outflow in the March quarter. Picture: Getty Images

Australia’s Reserve Bank may be showing the way. The RBA has so far stopped lifting rates even with inflation not forecast to return to the top of its 2-3 per cent target band (soon to be 2.5 per cent) until mid-2025.

How the US and European banking crisis plays out will also be important. Opinions on the crisis ranged from “systemic” to “idiosyncratic”.

There’s no doubt this crisis had a major impact on global markets last month. And at least in the US, the regional bank crisis hasn’t gone away as fast as markets expected.

First Republic Bank fell 80 per cent in two days, after revealing it suffered a $US100bn deposit outflow in the March quarter, minus the $US30bn ($45bn) that big banks tipped in last month.

Big US banks may be forced to accept an even less palatable rescue scheme rather than just the $US30bn. The latest reports suggest regulators want a private rescue that doesn’t involve the US government seizing the bank and taking a huge hit to the FDIC’s insurance fund.

But the big banks that could come to the rescue want more aid from the government.

CNBC said First Republic’s advisers have lined up potential buyers for new shares in the bank.

However, the big banks that deposited the $US30bn would need to buy US treasuries from First Republic for more than their market value, suffering an immediate loss worth billions.

Still, if First Republic survives, those banks could benefit as its shares recover, and they would avoid a bigger loss on the deposits they made plus any FDIC fees that would follow a failure.

As has been seen many times in recent decades, crisis – or rather the reaction of regulators including central banks and governments to crisis – can spawn major rallies in risk assets like shares.

Last month, the generous liquidity scheme that was rapidly implemented by the Fed after the collapse of Silicon Valley Bank pushed the S&P 500 above pre-crisis levels, even though the crisis threatened to trigger a credit crunch amid an already shrinking money supply.

Trovio chief investment officer Vimal Gor.

The Covid-19 pandemic led central banks and governments to unleash unprecedented fiscal and monetary policy stimulus that quickly spawned a major rally in shares despite the pandemic gloom.

The bearish majority at the Alpha Live conference said the US banking crisis wasn’t systemic and wouldn’t halt central bank tightening or prompt a renewed expansion of central bank balance sheets, stagflation was likely and central banks might eventually need to lift their policy rates above the level of inflation.

In their view investors with a short-to-medium term horizon should stick to cash, defensive assets and inflation hedges, or at least focus on quality stocks in what will at best be a range-bound market.

At the other end of the spectrum, Trovio chief investment officer Vimal Gor said rate hikes were mostly finished.

He said the US regional bank crisis was a manifestation of broader systemic risk caused by rate hikes and a collapse of lending, which is bringing forward a “balance sheet recession”.

“The RBA, pretty much every central bank in the world, will be cutting rates latest this year and aggressively next year, so I think you can go out and buy pretty much every asset class now.”

In his view the S&P 500 is driven by central bank liquidity and he sees this increasing in a big way this year with central banks set to cut rates and they pivot back to quantitative easing.

The response of the Fed and US Treasury to the regional banking crisis was large and immediate, so “just because things look bad (it) doesn’t mean assets can’t go up,” Mr Gor said.

He noted that retail shorts in US Treasuries and shares were near their largest levels in history.

“So you’ve got a market titled towards large short positions on a diversified book, in the worst environment, which normally would make sense apart from when you’ve got a liquidity flood. I would argue that liquidity is the tide that raises all boats and will raise all asset classes.”