Market Extra: Stock market starts to price ‘rising risk of stagflation,’ says Research Affiliates CEO. Here’s how investors may be positioning.

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Equity markets are starting to price “the rising risk of stagflation,” according to Research Affiliates chief executive officer Chris Brightman. 

“Investors are repositioning portfolios to protect the real value of their financial capital,” Brightman wrote in a Research Affiliates note this month. “Capital markets have panicked as investors try to anticipate how soon the Fed will be able to reduce inflation back to target” and whether the Federal Reserve’s tightening of monetary policy will lead to a recession, he said in the note.

Both stocks and bonds have sold off this year amid the highest cost of living in about four decades and slowing economic growth. Brightman, who is also chief investment officer at Research Affiliates, sees “a greater than one-in-three chance” of stagflation, a scenario in which the U.S. may end up grappling with both high inflation and a recession.

“If the Fed fails to tame inflation and we have a recession or two, then expect capital markets to behave as in the late 1970s and early 1980s,” Brightman said. “Interest rates will soar toward or above the-then current rate of inflation,” he said, while “equity prices will tank” as price-to-earnings multiples contract.

See:‘You don’t want to own bonds and stocks’ in this environment: Paul Tudor Jones

Today, the cyclically adjusted price-to-earnings ratio known as Shiller’s CAPE is well above 30, according to his note. During the last period of stagflation, “Shiller’s CAPE fell to below 10 in 1977, bottomed at 7 in 1982, and failed to rise back above 10 until 1985.” 

Based on where the price-to-earnings multiple now stands, “a fall even just to 10 implies a frightful decline in stock prices,” Brightman wrote. 

Read: Stock-market investors are ‘running scared’ amid most bearish sentiment since 2009, says BofA

U.S. inflation measured by the consumer-price index has soared to a rate of 8.5% in the 12 months through March. “How can a fed-funds rate of 3% tame CPI running at 8%?” said Brightman. “I perceive at least even odds that the Fed fails to get inflation under control soon.” He also estimated “at least even odds” for a recession before the end of next year.

Under the threat of stagflation, investors “may reduce exposure to equity beta and nominal duration by selling mainstream stocks and bonds in favor of commodities and real assets, whose prices have historically risen in response to rising inflation,” according to the Research Affiliates note. 

“Investors may protect the real value of their bond principal by swapping out of nominal bonds into TIPS,” or Treasury inflation-protected securities, said Brightman. And, “as is evident from recent movements in stock prices, investors will flee from longer-duration growth stocks and rotate into lower-duration—and exceptionally cheap—value stocks in their equity portfolios.”

The U.S. stock market was choppy Tuesday but ended higher, the day before Fed Chair Jerome Powell will hold a news conference at the conclusion of the central bank’s two-day policy meeting Wednesday.

Also see: Will Fed rate hike be a ‘clearing event’ for battered U.S. stock market? What investors are watching for on Wednesday

All three major U.S. stock benchmarks have been battered this year, with the S&P 500

down 12.4%, the Dow Jones Industrial Average

falling 8.8% and the technology-heavy Nasdaq Composite

tumbling 19.7%, FactSet data show. 

Citigroup analysts said in a research report dated April 29 that “global equity markets are moving to price in three stagflation themes — high inflation, rising rates, weak growth.”

They suggested a global equity strategy aimed at hedging against those three themes. “It is long commodity stocks, long defensives, and short (real) rate-sensitive Growth stocks,” the Citi analysts wrote. “Investors fearing that commodity prices are rolling over should switch into Financials.”

Citi’s stagflation portfolio has benefited from an “overweight” to commodity-exposed sectors and market, but strategists at the bank are “bearish on oil, citing the prospect of weaker demand and increased supply,” according to the report.

Also, weakness in China’s economy may “put metals prices under pressure,” the Citi analysts wrote. So, “commodity stocks are probably the first part of the stagflation portfolio that we would let go.”

In an April report from Ray Dalio’s hedge fund firm Bridgewater Associates, co-chief investment officers Dalio, Bob Prince and Greg Jensen warned that “stagflation is the big risk and the war in Ukraine has added to that.” The war has amplified “pre-existing pressures,” with the largest impacts in commodities markets where Russia is a major supplier, they wrote.

“The Fed and other central bankers face a challenging policy dilemma with a collection of uncertainties and risks as great as any since the 1970s,” the Bridgewater co-CIOs said.