Recent signs of stickier-than-expected inflation have some Wall Street strategists concerned that investors have become too optimistic about the odds of a soft landing in the US economy.
The prevailing concern is that inflation could enter an era of stagflation, where price increases reaccelerate while economic growth slows. This was most famously seen during the 1970s and 1980s when a swift move down in inflation proved to be a head fake, and the US was left fighting higher prices for more than a decade.
"We believe that there is a risk of the narrative turning back from Goldilocks towards something like 1970s stagflation, with significant implications for asset allocation," JPMorgan chief market strategist Marko Kolanovic wrote in a note to clients on Feb. 21. He expects the S&P 500 to fall to 4,200 by the end of the year.
A string of hotter-than-expected inflation reports in January have led Kolanovic and others to conclude that inflation's bumpy path to the Fed's 2% target should have investors worried as stocks sit at all-time highs.
"Although it's low probability, it's likely that investors are under estimating the chance for stagflation in the next 12 to 18 months," State Street Global Advisors chief investment strategist Michael Arone told Yahoo Finance. "And I think if anything, the last few years have taught investors that kind of low probability outcome happens far more often than the statistics suggest that it should happen."
If stagflation were to take hold, real assets like commodities outperform stocks and bonds, per Arone.
"Should this kind of low probability outcome occur, investors will be better for it by having a modest allocation somewhere in the 5% to 10% range into some of those kind of real assets," Arone said.
The inflation debate
MarketGauge.com chief strategist Michele Schneider flagged stagflation as a key risk for 2024 in January's edition of the Yahoo Finance Chartbook. She noted "startling similarities" between the path of the Consumer Price Index (CPI), when she first began working in markets in the late 1970s to now.
In the 1970s and 1980s inflation story, an oil embargo and a war in the Middle East helped spark inflation. The government spent significantly during and after the Vietnam War, which also contributed to rising prices. These factors paint a similar picture to now. Impacts from the COVID pandemic and recovery caused inflation to surge higher, and conflicts in the Middle East have impacted oil prices and fueled supply chain issues. Government spending also remains a key concern.
Schneider highlighted some warning signs already flashing in commodities. Sugar futures are up four times their pre-pandemic price, per Schneider, and cocoa prices have surged too. Invesco's agriculture ETF (DBA) is pushing against the highs seen during the 2022 inflation surge.
"There are some real issues here within food, which is kind of exactly what happened in '79," Schneider told Yahoo Finance on Feb. 27.
Add on that oil (CL=F) just passed $80 a barrel for the first time since November, and many of the same ingredients that sparked the return of inflation at the end of the 1970s are at play today, per Schneider. She added that a key turn — silver futures (SI=F) outperforming gold (GC=F) — has yet to happen.
One of the risks to stocks is that the Federal Reserve won't cut rates as quickly as markets hope. Investors are pricing in three interest rate cuts in 2024, per Bloomberg. Apollo Global's chief economist Torsten Sl?k predicted in a note Friday that the Federal Reserve won't cut interest rates at all this year.
"Underlying measures of trend inflation are moving higher," Sl?k wrote. (Disclosure: Yahoo Finance is owned by Apollo Global Management.)
But many economists have argued inflation is clearly headed lower. Capital Economics chief North America economist Paul Ashworth told Yahoo Finance he believes this bout with inflation will be more similar to the price spike after World War II, which didn't end in stagflation. The key difference is the 1970s brought a "whole succession" of supply shocks, he said.
The prospect of geopolitical tensions causing oil prices to jump even more this year always remains a key risk, Ashworth said. But for now oil prices remain lower than seen during their 2022 spike.
Ashworth highlighted other factors like the surprise growth seen in the US economy over the last year, which could indicate an uptick in productivity. This would keep the economy in balance even if demand remains strong.
"We think the odds of a near-term resurgence in inflation now are quite low because, even if demand remains strong this year in response to Fed rate cuts, there is plenty of scope for further significant gains in the supply-side of the economy," Ashworth wrote in a research note on Jan. 26.
Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.
Click here for the latest stock market news and in-depth analysis, including events that move stocks
Read the latest financial and business news from Yahoo Finance