Central bank response critical for market reaction to a stagflation scenario.

In our recent paper Research Global: 'Stagflation' risks on the rise, 15 Sept.ember, we discussed the risk that the global economy could face a (mild) stagflation scenario where inflation pressures turn out to be more persistent while the global economy continues to slow. This is not our base case - we see about a 30% chance of a stagflation scenario playing out. A key factor behind this scenario is that supply constraints like labour shortages and supply chain problems persist for longer than expected, reducing potential output and resulting in further rising wage pressures, possibly spilling into higher inflation. While we think central banks will be patient with regard to reacting to the high inflation (especially given the weak underlying economic momentum), we think they will ultimately tighten monetary policy to avoid a de-anchoring of inflation expectations, with the Fed tightening faster from 6M-24M and the ECB taking action in H2 22 if inflation pressures stay elevated in H1 22.

In this paper we discuss the market implications in such a scenario across different product groups, where central banks combat higher inflation with tighter monetary polices (see summary table below). A monetary policy tightening in the US seen in a strong rise in short-end US real rates, in a relatively low growth environment, will in our view provide a substantial hit to global risk sentiment, partly reinforced by a materially stronger USD, sending global equities lower and credit markets spreads wider, especially the high yield segment. While longer rates would initially increase, we think the significant hit to the global growth outlook would reverse the sell-off at the long-end of rates curves, forcing a flattening of yield curves. The verdict by central banks on inflation is likely to be made in early parts of 2022.

 

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