Inflation has become one of the most pressing global economic problems today. Rising prices have dramatically reduced both the overall wealth and purchasing power of much of the developed world.
And while inflation is certainly one of the biggest drivers of the economic crisis, a bigger danger looms on the horizon: stagflation.
Stagflation and its effect on the market
First coined in 1965, the term stagflation describes an economic cycle with a consistently high rate of inflation combined with high unemployment and stagnant demand in a country’s economy. The term was popularized in the 1970s when the United States entered a protracted oil crisis.
Since the 1970s, stagflation has been a recurring phenomenon in the developed world. Many economists and analysts believe that the United States is about to enter a period of stagflation in 2022, as inflation and the rising unemployment rate become increasingly difficult to control.
One of the ways to measure stagflation is to use real rates, that is, interest rates adjusted for inflation. Examining real rates shows real yield and real asset returns, revealing the real direction of the economy.
According to US Bureau of Labor Statistics, the consumer price index (CPI) recorded an inflation rate of 8.5% in July. July’s CPI posted an increase of just 1.3% from its May figures, prompting many policymakers to ignore the severity of the current inflation rate.
However, the actual rates paint a much different picture.
The 10-year US Treasury yield currently stands at 2.8%. With inflation at 8.5%, the real yield on US Treasuries is 5.7%.
In 2021, the size of the global bond market is estimated to be around $119 trillion. According to Securities and Financial Markets Industry Association (SIFMA), of which about $46 trillion comes from the US market. All SFIMA tracks of the fixed income market, which include mortgage-backed securities (MBS), corporate bonds, municipal securities, federal agency securities, asset-backed securities (ABS) and money markets, have currently negative returns when adjusted for inflation.
The S&P 500 also falls into the same category. Shiller’s price-to-earnings (P/E) ratio puts the S&P index in the extremely overvalued category. The ratio shows the inflation-adjusted earnings of the S&P index for the past 10 years and is used to measure overall stock market performance. The current Shiller P/E ratio of 32.26 is considerably higher than levels recorded before the 2008 financial crisis and is comparable to the Great Depression of the late 1920s.
The real estate market also found itself in difficulty. In 2020, the value of the global real estate market reached $326.5 trillion, an increase of 5% from its 2019 value and a record high.
A growing population that is fueling a housing shortage is expected to push that number even higher this year. In the United States, interest rates have been set near zero since the 2008 financial crisis, making mortgages cheap and boosting home sales across the country.
The rise in interest rates observed since the beginning of the year should change the situation. Starting in January, the National Association of Home Builders (NAHB) housing market index saw its fastest decline of -35 in history. The decline recorded in the index was faster than in 2008 when the real estate bubble suddenly burst. It is also the longest monthly decline for the NAHB index, with August marking its 8th consecutive month of decline for the first time since 2007.
With nearly every segment of the market posting declines, we could see a significant number of institutions and asset managers reconsidering their portfolios. Overvalued real estate, overbought stocks and negative real return bonds are all heading for a period of stagflation that could last several years.
Large institutions, asset managers and hedge funds could all be forced to make a stark choice – stay in the market, weather the storm and risk short and long-term losses, or rebalance their portfolios with various assets that have a better chance of growing in a stagflationary market.
Even if only certain institutional players decide to go the latter route, we could see an increasing amount of money flowing into Bitcoin (BTC). The crypto industry has seen unprecedented growth in institutional adoption, with non-Bitcoin assets becoming an integral part of many large investment portfolios.
However, as the largest and most liquid crypto asset, Bitcoin could be the target of the majority of these investments.