Banking turmoil and why investors should brace for ‘stagflation’

Recent stress in the banking sector has complicated the US Federal Reserve’s mission of fighting inflation. It has also made an economic recession much more likely.

US stock investors, however, seem to be shrugging off such risks. Following regional bank failures earlier this month, fixed income investors rushed to the perceived safety of US government bonds, driving up their prices amid concerns about the economy’s prospects. As a result, yields on US Treasury bonds saw jaw-dropping declines as traders began anticipating an earlier pause in Federal Reserve rate hikes.

Stocks, meanwhile, continued trading in a relatively narrow range, despite the obvious risks that banking stress poses to the economy. What seemed to matter to stock investors was the potential for a dovish Fed pivot—from raising interest rates to now pausing, and even lowering rates—that might spark a new bull market.

Today’s stock-market resilience seems to shrug off mounting risks of a hard economic landing, weakening corporate profitability and “stagflation”—when inflation remains high, the economy slows, and unemployment rises.

Here are three reasons why this scenario seems increasingly likely:

• Banking industry turmoil will likely lead to tighter lending standards and financial conditions. Regional banks with less than $250 billion in assets account for a significant percentage of loans made in the US if struggling regional banks tighten the growth of commercial and industrial (C&I) loans, growth in U.S. gross domestic product (GDP) could slow. When C&I loan growth slows, unemployment is apt to rise. Recent tightening of lending standards suggests the unemployment rate could increase by 2.5 percentage points in the next one or two years.
• Regional banks’ overall profitability is likely to come under pressure, which could put further stress on the economy. Banks could see increasing competition for customer deposits from higher-yielding Treasuries, certificates of deposit (CDs), and money market funds. To retain deposits, banks may need to increase the interest rates they pay depositors, which could squeeze bank profit margins.
• Concerns about financial stability could force the Fed to drop its inflation-fighting efforts prematurely. Price pressures remain relatively high. The risk is that inflation stays higher for longer, even as the economy slows—a recipe for stagflation that would likely see consumers suffer a decline in spending power once their incomes are adjusted for inflation.

Although the turmoil in the banking sector may indeed presage a sooner-than-expected pause by the Fed, equity investors would be wise to acknowledge the growing risks to the economy.

Pay attention to economic data, including inflation and unemployment. Stay patient, and in the current environment play defense by considering bonds for yield and dividend-paying stocks for income. For example:

• Cash and cash equivalents as well as short-duration bonds, which are less interest rate sensitive, may offer yield opportunities.
• Dividend-paying stocks, like those of U.S. companies with a track record of increasing their dividends, as well as global stocks that pay dividends, could add diversification and offer income opportunities.

The source of this article, Why Investors Should Brace for ‘Stagflation’, was originally published on March 29, 2023.