The looming spectre of stagflation
With the U.S. stock market hovering at levels some describe as ‘stretched’, economic indicators are flashing mixed signals, prompting some observers to raise the spectre of stagflation – a toxic brew of stagnant growth and persistent inflation.
Recent headlines, like The New York Times‘ August 15 declaration that “The stock market is getting scary,” reflect increasing nervousness. Economist Burton Malkiel has warned that valuations are approaching their highest in 230 years, with investor optimism possibly turning into “delusion”. Meanwhile, portfolio managers at firms including Morgan Stanley, Deutsche Bank, and Evercore are preparing clients for a 10-15 per cent fall in equities, while Goldman Sachs points out the “latent risk of unwinds” after a fragile “Goldilocks” period.
Meanwhile, a Goldman Sachs indicator says commodity trading advisor (CTA) positioning in US stocks is at the 100th percentile of maximum long. And Bank of America’s Global Equity Risk-Love indicator – a market sentiment index – jumped to 1.4, its highest in 13 months. According to several reports, margin debt is extreme everywhere, at decade-highs in China, and at record highs in the US back in July.
With bullish sentiment pervasive, what are the implications of stagflation, or even a narrative that switches from optimism to fears of stagflation?
Signs of stagflation
Stagflation isn’t a theoretical monster; it’s a real economic malaise featuring rising prices amid faltering growth. And it defies traditional policy tools. For some investors, recent data paints a worrying picture. August’s ISM and S&P Global factory reports revealed elevated input prices amid weakening growth, with leading metrics signalling further labour market cooling – potentially the first labour force contraction in decades.
Core personal consumption expenditures (PCE) inflation has accelerated to three per cent on a three-month annualised basis, up from 2.3 per cent in December 2024, driven by both services and goods. Super-core services consumer price index (CPI) (excluding food, energy, and shelter) jumped 0.5 per cent month-over-month, annualising to three per cent, while upstream producer prices index (PPI) pressures hit five per cent annualised over three months. As tariffs ramp up – from an effective 10 per cent today to 15 per cent or more in the coming months – it is feared these pressures could intensify, pushing year-over-year core PCE toward 3.5 to four per cent.
It’s these stats that evoke a classic stagflationary trap for some investors.
Under Trump, and given a deteriorating employment picture, the Federal Reserve may be compelled to ease policy despite elevated inflation to stave off recession, yet such moves could entrench higher prices.
Complicating matters, front-end bond volatility is artificially suppressed by Treasury buybacks – totalling $US138 billion this year, up from $US79 billion in 2024 – and a shift away from longer-term debt issuance. Treasury Secretary Scott Bessent has emphasised cheaper short-term borrowing, especially under pressure from President Trump to slash rates. Yet, as the Merrill Lynch Option Volatility Estimate (MOVE) index dips to parity with realised volatility and lags behind other asset volatilities, this calm might suggest fragility, rather than resilience.
As Benoit Mandelbrot famously observed, volatility spikes and clusters after long periods of calm. This could potentially spike long-end yields and steepen the yield curve abruptly.
Adding fuel to the fire is the Trump administration’s aggressive push for rate cuts, despite evidence to the contrary. Bessent’s claim that models justify 150-175 basis points lower rates is in conflict with the Taylor Rule, which pegs current rates as appropriate.
Recent CPI data – 2.7 per cent year-over-year, with core at 3.1 per cent and accelerating on shorter horizons – offers no justification for easing rates. PPI is even hotter at 3.3 per cent overall and 3.7 per cent core. Meanwhile, 1-2 year Treasury Inflation-Protected Securities (TIPS) yields hover at 3-3.5 per cent, suggesting inflation expectations are already unanchoring, and hinting at higher inflation ahead.
So, why the urgency to cut rates? It could be to boost employment, but perhaps a desire to refinance debt more cheaply? Or could it be to reward Trump’s personal purchases of $US100 million in bonds?
Policy missteps fuelling the risk
In the U.S., presumed efforts toward disengagement and domestic self-sufficiency – via tariffs and departures from global institutions, as well as domestic institutional assaults – mirror China’s “involution,” or overproduction driven by excessive savings rates (still at 45%). China’s July data revealed PPI deflation for the 34th month (-3.6 per cent), zero-bound CPI, declining capacity utilisation (e.g., autos at 71 per cent vs. pre-COVID 78-80 per cent), and weak credit impulses, with real estate prices dipping another 0.3 per cent month-over-month.
As an aside, it’s worth keeping in mind that totalitarians only have two levers to pull – economic prosperity and nationalism. If they fail at creating economic prosperity, they can and have turned to nationalism. The latter is fuelled by the creation of an adversary and a justification for going to war with them.
For the U.S., the assault on institutions is stark: Trump’s attempted firing of Fed Governor Lisa Cook marks the first such move in the central bank’s 111-year history, coupled with public berating of Chairman Powell – the clearest threat to Fed independence since Nixon.
Meanwhile economic surveys are being politicised. Witness, for example, the Census Bureau survey asking businesses how interest rate changes over the past six months ‘negatively’ impacted them, offering no option to report positive or neutral effects. This framing suggests a deliberate attempt to elicit responses that support the Trump administration’s specific narrative – namely, that high interest rates are harming businesses. This, of course, aligns with the administration’s push for lower rates (as noted with Treasury Secretary Bessent’s advocacy). Clearly, such surveys appear designed to produce results that justify political goals (i.e., pressuring the Federal Reserve to cut rates) rather than objectively assessing economic conditions.
And why should investors worry about that?
Recall Turkey under Erdogan, whose unconventional response to fighting inflation was cutting interest rates. This led to 70-75 per cent spirals in 2022 and the Turkish Lira’s collapse. If Trump errs similarly, stagflation could ensue in the U.S., with the Fed’s impaired autonomy fuelling unchecked inflation. Tariffs, already distorting prices, compound this: they invite corruption, reduce competition, inflate costs, limit choices, and provoke retaliation, eroding growth over time. While businesses may absorb initial hits via inventory drawdowns, the negatives accumulate, sapping productivity and consumption.
Globally, these “self-inflicted wounds” from two economic giants will force adaptation. Economies like Indonesia, India, Brazil and the EU will hedge against U.S. volatility and China’s inevitable flood of excess capacity, fostering protectionism and economic self-sufficiency or autarky.
By way of example, and a foretaste of what might occur elsewhere, Indonesia’s current public unrest, including deadly protests this week, stems from job stagnation, exacerbated by Chinese overproduction and dumping.
Economic and societal consequences
If stagflation did take hold in the U.S., the consequences could be complex and enduring. Domestically, embedded inflation could unchain long-term expectations. The economy, already described by some as “softening but strong,” is cracking: Q2 2025 gross domestic product (GDP) revisions were AI-driven, masking weakness elsewhere, including in consumption, non-IT investment, and government spending.
Nominal U.S. GDP is up 4.5 per cent year-over-year (near the 2000s average of 4.6 per cent), real GDP is at two per cent (vs. 2.2 per cent), and unemployment is at 4.2 per cent (below the 5.7 per cent average), but Trump’s tariffs threaten to drag these lower. Meanwhile, real retail sales lag at 0.9 per cent annually, inventory/sales ratios are elevated, and exports/imports dipped in June. These trends are expected to persist.
Elsewhere, bond markets, with their suppressed volatility, run the risk of sharp corrections, and if that happens, equity markets never like it. Neither does the real economy, because a steeper curve and higher yields could choke borrowing, hitting housing (new home sales at 627,000 annualised vs. 697,000 average) and small businesses (21 per cent cite labour quality and uncertainty as top issue).
The U.S. government’s financial health, specifically the U.S. budget deficit, is worsening. The federal budget deficit for July 2025 was $US289 billion, contributing to a year-to-date deficit of $1.6 trillion for the fiscal year. This represents an increase of $US109 billion compared to the same period in the prior year. The key concern here is that government spending (outlays) grew by seven per cent, outpacing the six per cent growth in revenues, despite a hitherto relatively healthy economy.
This imbalance signals a growing reliance on borrowing to cover expenses, which could strain fiscal sustainability over time, especially if economic growth slows or interest rates rise, increasing the cost of servicing debt.
In a potential stagflationary environment (rising inflation with slowing growth), this fiscal trajectory becomes riskier, as it could exacerbate inflationary pressures or limit policy options.
Stagflation also hits society hard. It makes everyday items more expensive, so consumers buy less. This squeeze makes life tougher for many, especially those with lower incomes, and it widens the inequality gap. Back in the 1970s, stagflation caused similar problems, leading to frustration and protests. It also changed how leaders thought about the economy, focusing more on impeding price increases rather than boosting growth.
On a global level, stagflation in the U.S. could turn countries inward, a reversal of globalisation. Nations like Canada and Mexico, which rely heavily on trade with the U.S., might have fewer choices to cope, similar to how Russia and Central Asia depend on China. This could lead to a world where trade and money flow less freely, where countries prioritise their own security, and global progress slows down as everyone focuses on protecting themselves.
We’re not there yet, but if the prospect takes hold of the investment narrative, the outcome for equities in the short term, and possibly the medium-term, would not be good.
What should equity investors consider?
For equity investors, enjoying stretched valuations amid optimism, the prospect of stagflation poses existential threats. Today’s warnings by major U.S. institutions recall historical episodes where stocks faltered, and faltered badly.
Nobody is talking about the 1970s, and hopefully they never do because that decade for the U.S. provides the starkest precedent: a decade of oil shocks, budget deficits, and policy errors, which led to high inflation (peaking at 13.5 per cent in 1980) alongside unemployment up to nine per cent in 1975. It decimated asset returns. The S&P 500 delivered nominal annual returns of about 6.3 per cent from 1970 to 1982, but after adjusting for inflation, real returns were negative at -0.9 per cent annually, as stocks struggled to outpace rising prices. Bonds fared even worse, with their real value eroded by the sustained inflationary surge. Back then, there were few alternatives. Today, however, investors are a little more fortunate, with easy access to gold, inverse exchange traded funds (ETFs) and private market investments such as private credit, offering an opportunity to diversify into more defensive asset classes or hedge risks by rebalancing portfolios by redistributing profits from impressively performing equities.
Both stocks and bonds tend to lag in stagflationary environments, with investors facing diminished real gains amid economic stagnation. The New York Times has highlighted how 1970s stagflation, tied to oil shocks, created a market malaise where equities languished, unable to hedge investors against persistent price hikes. Reuters echoes that the era featured the “worst U.S. economic leadership,” with high joblessness compounding inflation’s drag on investments. The oil embargo and loose policies fueled uneven growth, pressuring stock valuations.
That decade serves as a warning that in stagflation, traditional havens could fail. Equities may post nominal gains but erode wealth in real terms, especially if growth stalls further. And more importantly. low single-digit nominal returns hardly compensate for the volatility endured. Meanwhile, today’s outperformance by some sectors of the stock market could prove scant comfort, thanks to rapid sector rotations amid tariff threats.
There’s also a narrative emerging that the U.S. dollar’s downtrend and persistent short positions in interest rate futures are a reflection of anticipated turbulence, not tranquillity.
As an investor, therefore, you might have to ask: Is my portfolio positioned to acknowledge the possibility that optimism crumbles into malaise?
Stagflation is one possible consequence of policy hubris (tick) and economic inertia (emerging). If it did eventuate, its consequences would likely ripple through Wall Street to the global economy and trade. For the U.S., it would mean entrenched inflation, subdued growth, and institutional erosion.
It’s important to acknowledge this isn’t inevitable – policymakers could pivot, but the current trajectory isn’t encouraging.
With valuations extended – thanks to a global consensus that AI advancements are good for society and therefore also universally great for investors (that’s not been history’s record when it comes to world-altering tech) – investors may need to worry less about stagflation, and more about the prospect of a consensus fearing its possibility.
A portfolio rebalance should be considered. What were the portfolio weights that you started out with – those that reflected your risk tolerance? Rebalancing back to those weights – for example, by moving some equity profits into more defensive asset classes (consider private credit without exposure to property developers) – should at least be discussed with your adviser. The economy’s “averageness” today might be masking a deeper fragility.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
