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What I Care About This Week | 2021 July 12

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by Franklin J. Parker, CFA

The Summary

The Details

Stagflation is back?

Stagflation is an environment in which the economy is stagnant, but inflation is high. This tends to yield lower stock prices, high unemployment, and rising prices—a bad combination! These moments are rare in economic history, but the late 1970s to early 1980s are a vivid reminder of how bad things can be, and—at least up until now—the Federal Reserve has been keen to avoid even a whiff of catalyzing such an environment.

So far in this recovery, however, inflation and economic growth have been in keeping with their expected trends, however, with inflation posting considerably hotter than expected over the past few months and economic growth normalizing, investors have begun talking about a possible stagflation scenario. Admittedly, these are tough environments to navigate, and most of the veterans who managed money through the Volker years have long since retired. In other words, there is little institutional memory of the nuance to managing through such an environment. The worry is legitimate.

I am not yet convinced that stagflation is on the horizon. My current thesis is that we are going to be stuck in a long-term low growth/low inflation environment for the foreseeable future (not unlike Japan). Of course, my view will change as the data changes. That said, it is my job to think through possible investment scenarios and have contingencies for them. I never want to be scrambling to think through a strategy for an unforeseen economic environment.

Generally speaking, the stagflation investment plan goes something like this:

The point is, there is a way to approach any economic environment. And, while I do not yet see stagflation on the horizon, there is a playbook for it.

Chart of the Week

FactSet reports that the S&P 500 is expected to report year-over-year earnings growth of 64%—the largest growth in over 10 years. This week’s chart is from FactSet, and shows their bottom-up target price vs closing price for various sectors. In other words, this is how undervalued/overvalued, they see current sectors.

Energy is clearly favored, followed by materials and communication services. This should be little surprise as energy was decimated by the Covid recession, and materials have benefitted from both the recovery and the recent bout of inflation. Real Estate is most fairly valued, and this is again little surprise.

Of most surprise to me is their assessment of technology—expected by FactSet to underperform the S&P 500 as a whole. After powering through the recession with relative ease, and leading the recovery, investor views have shifted on technology. Of course, that isn’t to say that individual companies won’t outperform, but that the sector as a whole may be out of favor.

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