The possibility of the economy entering a stagflation period similar to the 1970s has raised concerns about the impact on the stock market. According to Sevens Report Research, even a small episode of stagflation could result in a significant decline of 10%-20% in stock prices, given that the market is currently trading at a high valuation of 21 times earnings. Stagflation is characterized by a combination of slow economic growth and high inflation, a scenario that plagued the U.S. economy during the 1970s. These concerns have intensified since the release of the March consumer price index report, which showed higher than expected inflation. While some economists, including Federal Reserve Chair Jerome Powell, have downplayed the likelihood of stagflation, pointing out that the current situation is not as severe as the 1970s, others argue that dismissing any talk of stagflation may be too dismissive given the potential risks.
According to Essaye, while economic growth is not currently indicating stagflation, recent data releases suggest that economic momentum is slowing. The ISM Manufacturing PMI fell below 50 in April, indicating a shrinking economy, and the Services PMI contracted for the first time since December 2022. Orders for durable goods in the US rose in March, but only marginally outside of the transportation sector, indicating ongoing weakness in manufacturing. The unemployment rate, although remaining below 4% in April, unexpectedly rose compared to the previous month, suggesting a cooling labor market. While consumer prices do not currently point to a repeat of 1970s-like stagflation, inflation has stopped declining and is showing signs of bouncing back, which could pose a problem for a stock market that is relying on lower Treasury yields to justify its valuation.
As of Monday afternoon, the forward 12-month pricing-to-earnings ratio for the S&P 500 stood at 21.5. According to FactSet data, the large-cap benchmark index has seen a nearly 10% increase this year. The concern is not that we will experience a 1970s-style stagflation to trigger a stock market correction, but rather that the current data trend is causing worry for investors in both stocks and bonds. This is an important distinction to keep in mind.
On Monday afternoon, U.S. stocks showed little movement, as investors awaited comments from Powell on Tuesday and the release of April’s CPI report on Wednesday. According to FactSet data, the S&P 500 remained relatively unchanged at around 5,222 points, while the Dow Jones Industrial Average dipped 0.1% and the Nasdaq Composite rose 0.3%.