Research Report: Stagflation?

BY: Richard Croft
Investopedia characterizes stagflation as a period of slow economic growth (declining GDP) and relatively high unemployment — economic stagnation — accompanied by rising prices – inflation. There are many third-world examples that lay bare the economic death spiral associated with stagflation. Lebanon and Venezuela come to mind, and heavily-sanctioned Russia will not be far behind.


Investopedia characterizes stagflation as a period of slow economic growth (declining GDP) and relatively high unemployment — economic stagnation — accompanied by rising prices – inflation.

There are many third-world examples that lay bare the economic death spiral associated with stagflation. Lebanon and Venezuela come to mind, and heavily-sanctioned Russia will not be far behind.

While the industrialized world is only dealing with one prong of the stagflation triple threat, there are fears that central banks’ hawkish rhetoric may lead to more aggressive tightening that could slow economic growth and dampen employment.

Initially, central bankers opined that inflation pressures and growth challenges resulted from supply chain friction that would diminish over time. As COVID waned, workers would return to the labour market, production bottlenecks would be resolved, output growth would accelerate, and U.S. core inflation – which last summer was running close to 4% – would settle into the U.S. Federal Reserve’s (the Fed’s) 2% target by late 2022. This target now seems far-fetched.

Our first issue is that COVID is nowhere near contained. COVID cases in Hong Kong are surging with the emergence of yet another, more contagious Omicron sub-variant. Although we are seeing a limited number of cases in mainland China so far, there are now spikes across much of Europe. As case counts rise and zero-COVID policies in China and the Asia Pacific Basin set in motion draconian lockdowns, the prospect of near-term supply chain normalization seems unlikely.

Nor can we see any short-to-medium-term alternatives. Consider semi-conductors as a case in point. Manufacturing chips domestically might alleviate supply disruptions, but over what timeline and at what cost? It takes time and very large capital investments to build new manufacturing facilities, and labour costs are significantly higher in North America.

Energy (i.e., fossil fuels) is another example. Despite political efforts to shame the industry, U.S. oil and gas companies are reluctant to ramp up exploration when the growing ESG movement discounts capital, skilled labour is in short supply and oil prices are at unsustainable levels.

Aggressive monetary and fiscal policies have been supportive. Consumers have healthy balance sheets and lots of disposable income, which has propelled above-trend economic recovery growth. But that will wane if inflation remains on its current trajectory. Just ask someone who has visited a restaurant recently. The cost of a decent meal is 20% to 30% higher than pre-pandemic levels.

More people have returned to the labour force as enhanced employment benefits have been reduced or eliminated (as of September 2021 in the U.S.) and there are plenty of jobs… ten million unfilled positions based on recent U.S. employment surveys. That’s good! However, a more competitive environment for workers means higher wages which, along with higher prices for fuel, commodity and supply chain constrained goods, could lead to much higher inflation.

Having acknowledged that their initial characterization of “transitory” was overly optimistic, central banks have become more hawkish. Over the past couple of weeks most of the major central banks raised rates by 25 basis points (0.25%). It would have been 50 basis points (0.50%) had it not been for the war in Ukraine. And while the rate hikes were a positive step, central banks are still reluctant to reduce their balance sheets. The Fed, European Central Bank and many other advanced-economy central banks remain fully committed to continuing their bond buying programs for much longer.

Although most have articulated a commitment to the tapering process, central banks have been lured into a “debt trap” by the surge in private and public liabilities (as a share of GDP) in recent years. Even if inflation stays higher than targeted, exiting QE too soon could cause seismic shifts in bond, credit, and stock markets. If aggressive actions were to cause a liquidity crisis, that would subject the economy to a hard landing, potentially forcing central banks to reverse policy and re-engage QE.

We’ve seen this scenario before. Between the fourth quarter of 2018 and the first quarter of 2019, the Fed attempted to raise interest rates and roll back QE. Credit and stock markets plummeted (see chart) forcing the Fed to reverse course.

Adding fuel to the fire was a politically motivated trade war with China, which increased costs, slowed economic growth and ultimately seized the repo-market. Central banks, in what became known as the “Fed Put,” re-started their QE programs and cut rates to stabilize markets. And this occurred a year before COVID shutdowns ravished world economies.

As COVID cases surged and governments introduced massive stimulus programs, central banks opened the monetary floodgates, and that led to the largest fiscal deficits since the Great Recession. The challenge now is whether the Fed can withstand the blowback should financial markets sell-off amid a slowing economy and high inflation?

And there are bigger uncertainties beyond the actions of central banks. Fragile supply chains, conflicts and threats of annexation advanced by tyrannical rulers, have all drawn into question the value of globalization and the current ‘world order’.

To this point, we believe demographics will define essential economic trends over the next three decades. Between 1950 and 1980, as the global population soared, the main concern was that the planet’s resources would no longer be able to meet the needs of an expanding populace.

More recently, birth rates have declined leading to a much greater-than-expected slowdown in population growth. Aging populations in advanced economies and emerging markets make it difficult to replace retirees unless immigration guidelines are relaxed. Especially so, restrictions that hamper immigration from poorer regions

Certain regions will experience a reduction in population over the next fifty years. Japan’s population is forecast to decline from 129 million people ten years ago to 90 million in 2070. Meanwhile, its working-age population peaked at 80 million at the end of the 1990s and is predicted to decline to just 49 million in 2050.

Climate change and political disruption will disrupt agriculture and heighten food price volatility. Future global pandemics will create systemic shocks that foster domestic self-reliance and tighter export controls on vital key goods and materials. State- and non-state-sponsored cyber warfare will disrupt production and can be costly to control. Growing political backlash against income inequality will motivate regulatory changes that will strengthen labour, lower productivity and slow growth.

The main concern is these factors threaten to stall recovery and reduce growth at the same time as aggressive monetary and fiscal policies combine to push prices higher. With debt to GDP ratios at all-time highs, if stagflation takes hold because of a 1970s-style wage and price spiral, the fallout would be historic.

We can only hope that central banks recognize the risk and can manage it accordingly.


Understanding the economic risks related to stagflation is one thing; developing a strategy to mitigate the fallout is another. For some insight, it is helpful to start with what we know. Central banks have done a masterful job telegraphing their inflation response. Principally, they will engage with rate hikes that, at a minimum, will take place through the end of 2022.

Last week, the Fed started the new rate cycle by hiking their overnight lending rate by 25 basis points (0.25%). Depending on how the Ukrainian conflict plays out, we expect further 25 basis point hikes over the next two Fed meetings. If the Ukrainian conflict is resolved (an even proposition, at best), then two 50 basis point hikes are on the table.

The yield curve will determine the impact on the credit markets. The markets are anticipating short term rate hikes will result in an upward sloping yield curve – i.e., rates rise from left to right on the accompanying chart.

More worrisome is if short term hikes cause the yield curve to flatten or, worse, invert (long rates are lower than short rates). Historically, an inverted yield curve is a warning that a recession is coming, typically within the next six to twelve months.

In terms of the number of rate hikes, we have been at the lower end of consensus. Our thinking is that the Fed will move cautiously and supplement rate hikes with balance sheet reduction. That would suggest a pause in the first cycle after two or three rate hikes. For this to pan out, the pause would be accompanied by a gradual reduction in QE, which could reduce their balance sheet by U.S. $500 billion by year end.

We acknowledge that the number of rate hikes in 2022 will hinge on the data, which is, at best, a moving target. Should inflation remain hot, rate hikes will continue, and likely be larger. Remember, central banks are trying to thread a very tight needle.

Because interest rate hikes reduce bond prices – with longer-term bonds declining more to adjust for their higher expected returns – we have underweighted that asset class. That is a tough call because, conversely, if higher rates or other uncertainties (e.g., war spreading beyond Ukraine, see below) seriously disrupt equity markets, a flight to quality would cause bond prices to rise. Our approach is to overweight short-term bonds and cash as a hedge against that possibility.

If higher rates have the desired upward-sloping impact on the yield curve, it will benefit financial institutions, notably banks and insurance companies. Banks borrow short term and loan longer term, so an expanding rate differential along the yield curve benefits their bottom line. Similarly, insurance companies benefit because a normal yield curve increases annuity payouts at a lower up-front cost. Also, value stocks should do better than growth stocks in a rising rate environment, mainly because the company balance sheets of value stocks tend to carry less leverage.

The wildcard remains the Ukrainian conflict or, more importantly, the risks that the conflict might expand beyond Ukraine’s borders. We will also be watching how China may attempt to take advantage of the Ukrainian invasion to further exert its influence with certain players, and even their decision whether to engage in a military conflict with Taiwan. If China sends military aid to Russia or, more importantly, helps Russia circumvent the sanctions, on the surface it does not appear that such actions are in China’s best interest. However, if annexation of Taiwan is the primary goal of the Chinese Communist Party, a closer alliance with a heavily-obligated Russia could be a viable strategy.

These are challenging times.


History will ask a very basic question. How did Vladimir Putin manage to revitalize NATO, unify a splintered West, turn Ukraine’s little-known president into a global hero, wreck Russia’s economy, and solidify his legacy as a murderous war criminal?

What follows is a thought-provoking essay by Brian Klass[1] who attempted to answer that question:

Understanding the thought process of a dictator begins by looking at the power and information ecosystems that drive their decisions. In my research, I’ve persistently encountered a stubborn myth – of the savvy strongman, the rational, calculating despot who can play the long game because he (and it’s typically a “he”) doesn’t have to worry about pesky polls or angry voters. Our elected leaders, this view suggests, are no match for the tyrant who gazes into the next decade rather than fretting about next year’s election. The reality is very different.

Autocrats such as Putin eventually succumb to what may be called the “dictator trap.” The strategies they use to stay in power tend to trigger their eventual downfall. Rather than being long-term planners, many make catastrophic short-term errors – the kinds of errors that would likely have been avoided in democratic systems. They hear only from sycophants and get bad advice. They misunderstand their population. They don’t see threats coming until it’s too late. And unlike elected leaders who leave office to riches, book tours, and the glitzy lifestyle of a statesman, many dictators who miscalculate leave office in a casket, a possibility that makes them even more likely to double down.

Despots sow the seeds of their own demise early on when they first face the trade-off between allowing freedom of expression and maintaining an iron grip on power. After arriving in the palace, crushing dissent, and jailing opponents is often rational, from the perspective of a dictator: It creates a culture of fear that is useful for establishing and maintaining control. But that culture of fear comes with a cost.

For those of us living in liberal democracies, criticizing the boss is risky, but we’re not going to be shipped off to a gulag or watch our family get tortured. In authoritarian regimes, those all-too-real risks have a way of focusing the mind. Is it ever worthwhile for authoritarian advisers to speak truth to power?

As a result, despots rarely get told that their stupid ideas are stupid, or that their ill-conceived wars are likely to be catastrophic. Offering honest criticism is a deadly game and most advisers avoid doing so. Those who dare to gamble eventually lose and are purged. So over time, the advisers who remain are usually yes-men who act like bobbleheads, nodding along when the despot outlines some crackpot scheme.

Even with such seemingly loyal cronies, despots face a dilemma. How can you trust the loyalty of an entourage that has every reason to lie and conceal its true thoughts? The ancient Greek philosopher Xenophon wrote of that inescapable paradox of tyranny: “It is never possible for the tyrant to trust that he is loved… and plots against tyrants spring from none more than from those who pretend to love them most.”

To solve this problem, despots create loyalty tests, ghoulish charades to separate true believers from pretenders. To be trusted, advisers must lie on behalf of the regime. Those who repeat absurd claims without blinking are deemed loyal. Anyone who hesitates is considered suspect.

In Kim Jong Un’s North Korea, for example, the lies have gotten progressively more ridiculous. Once a lie becomes widely accepted, the value of that individual loyalty test declines. Once everyone knows that Kim Jong Un learned to drive when he was just 3 years old, a new, more extreme lie must emerge for the test to serve its purpose. The cycle repeats itself, and a cult of personality is born.

Plenty of people around Putin understood that dynamic, which is why they were willing to parrot Putin’s outlandish claim that the Jewish president of Ukraine, Volodymyr Zelensky, is presiding over a “neo-Nazi” state. (Such mythmaking can happen in democracies too if you have an authoritarian-style leader. Just consider how many Republicans have fallen over one another to endorse Donald Trump’s lies about the 2020 election to prove their MAGA bona fides.)

But to stay in power, despots must worry about more than just their advisers and cronies. They must win over, intimidate, or coerce their population too. That’s why dictators invest in state-sponsored media. In Russia, the state goes so far as to present fake presidential candidates who pretend to oppose Putin in rigged elections. The whole system is a Potemkin village, an illusion of choice and political debate.

Again, that mechanism of control comes with a cost. Some citizens brainwashed by state propaganda will support a war that is sure to backfire. Others privately oppose the regime but will be too afraid to say anything. As a result, reliable polling doesn’t exist in autocracies (Russia is no exception). That means that despots like Putin are unable to accurately understand the attitudes of their own people.

If you live in a fake world long enough, it can start to feel real. Dictators and despots begin to believe their own lies, repeated back at them, and propagated by state-controlled media. That might help explain why Putin’s recent speeches have stood out as unhinged rants. It’s certainly possible that his mind has succumbed to his own propaganda, creating a warped worldview in which the invasion of Ukraine was, as Trump put it, an incredibly “savvy” move.

The risks of miscalculation are compounded, psychology research has shown, by the fact that power literally goes to your head, including in a keyway that may be relevant in explaining Putin’s costly gambit in Ukraine. The longer someone is in power, the more they begin to get a sense of what is known as “illusory control,” a mistaken belief that they can control outcomes much more than they can. That delusion is particularly dangerous in dictatorships, in which there are virtually no checks or balances, no term limits or free elections to boot someone from power.

Some Russia experts, such as Fiona Hill, have recently suggested that Putin has spent much of the pandemic isolated and alone, poring over old maps of the lost Russian “imperium.” Cumulatively, it’s possible to imagine how these factors combined to convince Putin that his brutal blunder in Ukraine was a good idea.

When despots screw up, they need to watch their own back. Yet again, they can become victims of the dictator trap. To crush prospective enemies, they must demand loyalty and crack down on criticism. But the more they do so, the lower the quality of information they receive, and the less they can trust the people who purport to serve them. As a result, even when government officials learn about plots to overthrow an autocrat, they may not share that knowledge. This is known as the “vacuum effect” which means that authoritarian presidents might learn of coup attempts and putsches only when it’s too late. This raises a question that should keep Putin awake at night: If the oligarchs were to eventually make a move against him, would anyone warn him?

Clearly, Putin is no fool. But as we debate possible endgames to the war in Ukraine, we shouldn’t kid ourselves. Putin, like many despots, isn’t behaving fully rationally. He inhabits a fantasy world, surrounded by people who are afraid to challenge him, with a mind that has been poisoned by more than two decades as a tyrant. He’s made a catastrophic mistake in Ukraine that may yet prove his downfall.

Democracy isn’t perfect. It’s messy. It can be shortsighted. Many powerful democracies, including the United States, are dysfunctional. But at least our leaders face real constraints, real pushback for their miscalculations, and real criticism from their population. And, crucially, there’s a built-in mechanism to replace our leaders when they start to behave irrationally or irresponsibly.

That’s why it’s time to jettison the myth of the “savvy” strongman, or the dictator who’s a geopolitical “genius.” Putin has fallen victim to the dictator trap and proved that he is neither.

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Richard Croft, Chairman & CIO

[1] Brian Klass has interviewed despots and dictators for more than a decade. He writes at

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