Breaking Down Stagflation

Joe: Welcome, everyone, to episode one of "Balanced PM," an XYPN podcast where we prioritize context over conviction to help you make better portfolio management decisions. We're your hosts, Joe Dunn and Andrew Almeida, coming to you from XYPN Sapphire. In each episode, we'll explore key principles behind investment management and portfolio construction through thoughtful, in-depth conversations.

From timely discussions of current events to the review of evergreen portfolio management concepts, we'll plan to cover a wide range of topics over our time here. But before we get into it, our chief compliance officer has already given us a look, so let's get that disclaimer out of the way.

This podcast is produced by XYPN Sapphire, an SEC-registered investment advisor that's wholly owned by XY Planning Network.

We're part of the same XYPN family, so we may make references to the larger network, and that's okay. This content is intended for educational purposes only and should not be construed as investment advice. Today's episode is all about stagflation. We'll cover the historical backdrop, connect it to what we're seeing today, and explore how it can factor into investment and portfolio decisions.

And with that, Andrew, I am excited to dive into episode one of "Balanced PM." Happy to be here.

Andrew: Yeah. Couldn't be more excited myself, Joe, to take this journey with you. I know how much hard work you're putting behind the scenes on this, and to just share more with our advisors, this is awesome.

Joe: And I think a good place to start with the topic of stagflation is, what is stagflation?

Andrew: Stagflation, couldn't be more of a timely topic. I think if people aren't hearing about this in the news now, they'll keep hearing about it more through the end of the year. It's a funny word, right? Like stagflation. Okay, stagnation and inflation. It's a period of high inflation and stagnation, meaning low growth.

There is one word that they leave out of there, it's a third component, and that's the unemployment piece. It's... So when you think about stagflation, it's actually three things: high inflation, low growth, high unemployment, in its basic terms. That's about as

Joe: The unemployment piece got shortchanged in the naming convention, but stagflation definitely rolls off the tongue a little bit better than stag-employ-flation or something like that. So I think they made the right call and Happy that they probably didn't spend too much time, the economist that is, coming up with a name.

They were focused on the real problems at hand. but not only is stagflation a trip- tricky topic to name, apparently, but it's also tricky to handle from a monetary policy standpoint, right? And that comes down to an implicit conflict in the way that the different components of stagflation respond to the major levers that central banks can use within monetary policy.

And so inflation rates, that's of course one of the major tools that central banks have at their disposal. And when we look at the three-- the different components of stagflation, we have stagnation, low economic growth, and high unemployment. And if we're trying to fix those two with interest rates, we would look to lower interest rates in order to stimulate the economy.

But then on the other side of things, we have the inflation piece. And as we've seen recently, during periods of heightened inflation, interest rates go up in order to try to control rising prices. So banks are really between a rock and a hard place if they find themselves in this situation.

Andrew: Yeah. It's a tough situation for central banks, and the conversation about the dual mandate and what's more important is, going to happen and continually get discussed. I think if you look at central banks around the world, the primary mandate really is price control as opposed to labor, but we'll get into how those things conflict and how economic theory has developed.

I'm sure if the economists could have made up stag employflation for some period they want to study, they would've. We'll talk about how economic theory's developed. But here, the key point is you're absolutely right. Psychologically, there's an impact on consumers who are getting squeezed from both ends.

Lower employment or, potentially higher unemployment, excuse me, and then higher prices. So even in higher unemployment, you could see a wage freeze. So even if they're not unemployed, the higher prices and wage stagnation could also hurt.

Joe: Or even just concern that you might lose your job. It doesn't have to actually happen to change your spending habits,

Andrew: That could happen to change your spending habits. Absolutely.

Joe: This isn't just conceptual. We don't have to think, "Oh, like how would people respond in a stagflationary environment?" Because this is something that has appeared in history. So we want to start this conversation with a little bit of historical context.

So let's take it back to, all right, where did the term stagflation originate? Somebody had to come up with it. and the term dates back to the mid-1960s, and it was actually our colleagues across the pond in the United Kingdom that came up with it. And I'm not going to spend too much time talking about their experience, because we want to focus on the US where our listeners are.

but I kinda want to point out what the different components of stagflation looked like at the time that this term was coined. So the UK was experiencing 4.8% inflation, 2.1% GDP growth, and 2.3% unemployment. And now it's important to note that things did get worse from there. They experienced higher levels of stagflation, but at the time that the actual term came to be, things actually didn't look terribly bad.

And I think that's important to point out because one of the big pieces of stagflation is there's no set definition to what stagflation is from a numerical standpoint.

Andrew: It's important to point out because one of the big pieces of stagflation is there's no set definition to what stagflation is from a numerical standpoint. Yeah, that's-- And that's important to understand, right? These are concepts that we use to put some description around a time period of e- of e- of economic time period, let's call it.

But it is all relative. And you mentioned the UK kind of coining the term in 1960. that's pre-US coming off of the gold standard and effectively the new global economic regime that takes over. So how you think about stagflation before and after that, I'm sure can easily be considered differently.

But numerically, the facts and figures are relative to other countries, other markets, your own employment and financial situation. I think there are, when we look at those three metrics, employment, growth, and inflation, the numbers could be, when they're at their extremes, easy to say, "Hey, that's stagflation."

But it's not... there is no single series of numbers that you'll say, "Yeah, that-- we're in the stagflation environment."

Joe: Yeah, it's all relative. But let's zero in on when we've actually seen stagflation pop up in the United States. And we're going to look back to a period that's generally considered stagflationary between 1968 and 1982. Now, it's important to note that not every single year within that period was considered a stagflationary year.

There were lots of ups and downs, periods of recovery and whatnot, and the peaks of the different components of stagflation didn't all happen at the same time. But the threat of stagflation was more or less looming over the United States throughout those years. So to give everybody a bit of a picture of what we were working with back then, let me summarize some of the most notable data points to lay out what stagflation looked like in the US at that point in time.

So between 1968 and 1982, there were actually four distinct recessions within that larger time period. On top of that, we had inflation that peaked near 15%. Unemployment peaked over 10%, and economic growth dipped below negative 2% on multiple occasions. So again, those didn't all happen at the same time, but that just kinda gives you an idea of where the extremes lie within that general timeframe. Now, Andrew, I'm sure some of our listeners, if they haven't done a historical deep dive into stagflation, before now, they're probably wondering, what caused stagflation? Was there something that we can point to so we can avoid that in the future?" And unfortunately, I wish I had an easy answer for you, but there really was no single cause.

It was more of a perfect storm of converging factors, if you will. The most commonly cited catalyst, I would say, is probably the supply shock piece of things. And within that time period, there were two specific events that led to massive supply shocks, and more specifically, oil supply shocks. We had the 1973 oil embargo and the 1979 Iranian Revolution.

Both of these events, in summary, just led to a disruption in oil supplies coming out of Iran and the Middle East, and a drop in supply led to an increase in oil prices, and that was a big contributor to our stagflationary environment. So I think a good place to kinda take it from here is, informing our j- our listeners as to why is the price of oil and the supply of oil such a big factor in the global economy, and how did it contribute to this whole thing?

Andrew: Yeah. The time period you bring up obviously is super interesting. We'll spend more time talking about the parallels, Iran then, Iran now. But it does come down to oil in many ways. Oil's your universal input, right? it goes in all energy and energy that makes the world go round inputs, by and large, and is still the pr- primary commodity that drives energy use.

So when we think about oil going up, the transportation of all goods that get moved via ship, via plane, their associated costs go up. Not to mention you have oil inputs in our plastics, fertilizer. There's a lot in which oil is involved in at, stage one or stage zero, and then prices follow with everything else that comes from there.

Joe: A lot of everyday consumers might not realize how much oil touches everything that we touch, but it does flow through to the prices, which they start to pick up on in periods of heightened inflation. But on top of the supply shock side of things, there was also some extreme fiscal and monetary pressures that contributed to stagflation that the U.S.

saw. And a lot of times, at least in the industry, we discuss fiscal and monetary pressures independently of one another because they come from different sources. But at least at this point in history, I feel like they were uniquely intertwined. So let me start with what was the foundation of the fiscal and monetary issues that they had.

So in the 1960s and 1970s, the U.S. faced a combination of fiscal and monetary pressures that exacerbated the impacts of one another. And there was no historical precedent for policymakers to navigate that sort of situation. So let's start with the monetary side of things. At this point in time, there was a massive global demand for the U.S. dollar. In 1970, the U.S. dollar represented roughly 80% of global currency reserves. And at that point in time, we were still operating under the framework of the Bretton Woods Agreement. Some of you might be familiar with it through the gold standard. And that the global financial system was built on this Bretton Woods Agreement. The dollar was directly backed by gold as well as other global currencies, and global currencies were exchangeable at fixed rates. And that whole framework really started to fall apart in the early 70s. The world needed more U.S. dollars than gold supplies could support because there was so much global trade happening in the U.S. dollars and global trade was really ramping up. And we'll circle back to the gold standard falling apart in a moment. But for now, the key takeaway for that piece is just remember that the monetary piece involved a massive global demand for U.S. dollars. So now let's add on top of that a fiscal component of it or government spending.

Domestically, in the 1960s, Lyndon B. Johnson, LBJ, cooked up the Great Society Initiative, which increased domestic spending aimed at reducing poverty, reducing racial injustice, and expanding social welfare. And obviously in my eyes, that is a very noble undertaking.

So it's important to acknowledge the inflationary pressure that government spending adds. So well-intentioned, but obviously there's side effects to that. And inflation was one of them in this case. On top of that, from the fiscal side, we also had some foreign objectives that the US was contending with at the time.

We had the Cold War and the Vietnam War. And as you can imagine, war, whether cold or hot in the case of Vietnam, takes a lot of money to fund, and it's not an option to stop spending at that point in time. You're in too deep, and you have to keep spending. So between domestic initiatives and foreign initiatives, the US was just spending a lot more money at that time.

And we were also coming out of a recession at the end of the '60s. There was a recession in 1969 leading into 1970. So you add on top of that elevated fiscal spending, add on top of that elevated global demand for US dollar without the gold to support it, and the global economy starts to thinkin', "Huh, maybe the US dollar is not as safe as we thought it was historically."

And there, we started to see cracks in confidence, and eventually there ended up being a global rush for central banks to convert their gold reserves-- Or sorry, to convert their US dollar reserves into gold due to that perceived risk of the US dollar. So in 1971, Richard Nixon withdrew the US from the Bretton Woods Agreement, and that effectively ended the gold standard.

Now, this gave them more flexibility to spend without worrying about gold convertibly and having to navigate the rigid requirements of the Bretton Woods framework, but it also ushered in a brand new, uncharted territory, if you will. And we were in-- We found ourselves in a brand new monetary regime.

Andrew: Yeah. Uncharted territory. I really, I like that word, Joe. And the context that you've provided us here is so important to-- from, physical policy, boots on the ground, geopolitics, what was happening during the times, what was happening with labor, how were governments spending. You really caught me off guard with LBJ being spending, governments being spending, but I want to put some economic theory and backdrop to this timeframe behind this, because you mentioned that very-- you're under kind of uncertain circumstances. And effectively what's happening here is you're shifting from what was the Keynesian way of thinking into what would be the monetarist way of thinking, right?

So from John Maynard Keynes to Milton Friedman, where sh- you know, the economic theory of how to, what? Deal with how humans, economics being the study of how humans exchange resources, which are limited, and how to do that efficiently. A lot of the time too, it almost comes out with a government prescription.

So that's why I joke about bringing up this government's spending, because the Keynesian approach was very... And consider what all economic theory is really working on as a goal, to prevent a deflationary period where just all spending freezes and people are waiting for lower prices tomorrow, so economic activity effectively stops.

You definitely don't want deflation. So governments use this economic theory to try and prescribe, how do we deal with that situation? The Keynesians, they're the government being spending guys. The monetarists move into this new regime where we go off the gold standard, we allow free currencies to float, and the idea is to control the money supply and in- and interest rates around that.

And during this time, this period, you mentioned, I think '68 to '82, the mayhem, which, you'll get into, or the conditions. But yeah, it was a new landscape to navigate, and it birthed new economic theory.

Joe: And with it being such a new environment that nobody had experienced before, it's really not terribly surprising that they made some mistakes along the way, and there were some really notable policy missteps. Back in 1994, Professor Jeremy Siegel, specifically said that it was the greatest failure of American macroeconomic policy in the post-war period.

And to your point about things evolving and the fact that economists have to use backward-looking data to inform forward-looking policy, at all. It's a matter of things working un- until they don't work, and things can go really haywire once they stop working. And one of those things that stopped working was the Federal Reserve's over-reliance on the Phillips curve.

And I know for some of our listeners, this might be one of the first times that they hear the term Phillips curve. So Andrew, if you could walk us through what is the Phillips curve and what were the implications at that point in time?

Andrew: Yeah. This was a policy mistake rooted in that kind of Keynesian thinking. Real short, the Phillips curve is an inverted relationship between unemployment and inflation. So as unemployment goes down, that means more people are working, inflation would go up because what? More people are spending money.

They have their jobs, and f- and the inverse being true as well. Now, Keynes argued and was famous for saying, "In the long term, everyone's dead," because even he had some recognition that this worked and was viewable in the short term, and that governments should take prescriptive action to remedy these situations by spending physically, right?

If there was any misalignment. that breaks down over the long term. So if effectively, you have a return to equilibrium when this relationship doesn't hold up, or this relationship not holding up is, effectively the beginnings of a stagflationary environment, and things out of whack, right?

So I, I think, that old Keynesian way of thinking with the Phillips curve and short-term thinking and physical spending starts to fall apart. The Fed realizes it, and yeah, as we said, more monetarism takes over.

Joe: if the Phillips curve held to a better degree and the inverse relationship between unemployment and inflation held, even I still think that Phillips curve was just too two-dimensional. One of the big things that it failed to capture was the impact of inflation expectations and the impact that has on the real economy.

If you have a consumer base who is expecting inflation, it really doesn't necessarily matter if the actual inflation numbers get to that point because they're going to adjust their spending and that's going to result in lower economic growth as a result the consumer experience, really does feed into what is actually happening in the economy.

Andrew: Yeah. Expectations are a lot. I'm glad you bring that up, Joe, because we measure inflation backwards, but how people react and spend in the present is based on what they expect to come.

Joe: And on top of all of this, there were some structural economic conditions that really contributed to the explosion of stagflation at this point in time. One of those things was there was a rapid labor supply growth in that post-World War II period. Think about it, during the wartime, we had a lot of manpower that went to either going overseas to help fight in the war or, domestic industrial capacity was repurposed for wartime purposes.

So once the dust settled and the war was over, all these soldiers and wartime factory workers had to find a new purpose within the domestic economy. And so we found an influx of new workers, but overall economic growth didn't keep up with that rapid increase in labor supply, and which ended up leading to lower average productivity, and that was a detail that really had to be considered at this point in time.

On top of that, we also had some regulatory changes that had an impact, like the creation of the EPA and OSHA, which similar to the social spending I referenced with Lyndon B. Johnson, it was well-intentioned, and the regulations were put in place to improve the quality of life for US citizens. But it comes with added regulatory frictions, which tend to be inflationary over time.

and the last detail that I'll mention from a structural standpoint is, at this point in time, there was a much greater risk of a wage-price spiral. So unions were a lot stronger back then. The labor market had much more collective bargaining power, and they could fight for increased wages. And they got those increased wages, and then the companies that had to pay them those increased wages saw their profit margins going down and said, "we have to increase the price of our products."

And so that adds to inflation. And then who's consuming those products? It's the very same people that work for them. So there's this back and forth of wa-- prices go up, so wages have to go up, so prices have to go up, and you can see how that can really spiral and get out of hand quickly. And so I kinda want to wrap all of that up, try to put a little bow on it so everybody can kinda summarize it in one fell swoop.

And the way I like to think about it is we had a period of loose fiscal and monetary policy during a period of massive global dollar demand, and that all created a big inflationary backdrop. On top of that, we had oil supply shocks, which exposed and intensified those inflationary pressures. And then we had the collapse of the Bretton Woods Agreement, which forced policymakers to navigate an entirely new monetary regime and make some mistakes along the way.

And this led to previously unseen combinations of high inflation, high unemployment, and low economic growth, AKA stagflation.

Andrew: Yeah. Joe, the context there and way, the way you just rounded that out, I think is perfect. There's a lot going on, right? There's a lot going on. One of the things I think you said that I really take away is especially, a little earlier was like, it works until it doesn't.

and you talked about the wage price spiral and the level of people and employment that came after World War II. There was so much work that was driven by the war effort, but then how do you keep these people working? How do you keep them productive? Okay, is there going to be some return to equilibrium?

we can't let that happen. How do we s- do we just spend? Do we keep spending our way out of this, right? So yeah, the short of it is that, a confluence of events and too many conflicting factors put you in a tough spot. The '70s was certainly a tough period to be in.

I think it eventually resolves itself through four recessions, you said?

Joe: Four recessions.

Andrew: Four recessions, to balance this time period out. and we're going to get into the parallels to, for today, which I'm super excited about. But you saw Fed funds rates as high as 20% to mean, to, try and bring, combat this inflation.

Joe: Is unfathomable for probably many of our listeners who weren't alive at that time.

Andrew: Yeah. Yeah, certainly I don't want a mortgage rate in those...

Joe: Yeah, I'd be a renter if that were the case. but obviously this is an investment podcast. We want to relate this to the ec- the economic piece into how that feeds through into the actual markets. and I know from an economics standpoint, we were focusing on 1968 to 1982, but I want to zoom in a little more from a market perspective and let's just look at a clean decade, the 1970s, which captures most of what we were talking about.

And the 1970s is seen as a lost decade for stocks. The Dow Jones Industrial Average gained less than 5% over that whole decade. The S&P 500 did a little bit better, and it gained around 17% over that decade. But it's also important to note that those rates of return are not adjusted for inflation. So if we were to adjust those for inflation, stock returns over the entire decade of the 1970s would've been well in negative territory But now that we've gotten through the historical context, I think that sets a pretty good foundation for the next part of the conversation, which is, all right, let's step back into the current day where we are, where our listeners are, and we've identified some key stagflationary themes through a historical lens.

but now let's try to draw some parallels between then and what we're seeing now. And of course, at Balanced PM, we aim to be balanced. So we're going to cover both sides of the coin and discuss what stagflation warning signs we see today and what we're seeing that gives us hope that we can avoid stagflation.

Because to be very clear, stagflation is not our base case assumption. We don't nec- we're not predicting that stagflation is around the corner, but it's important that we acknowledge that it is a distinct possibility. So we want to take that balanced approach and kinda let's circle back through all the themes that we touched on and how we're viewing them today.

And I think the one that's front and center on everybody's minds right now is inflation and the external shocks that we've seen that are contributing to inflation, namely the conflict in Iran, the impact that's having on the Strait of Hormuz as a major shipping lane for oil, and the impact that the global oil supply has on prices and inflation.

want to start us off with-- Or actually, so we're going to break this down, and first we're going to cover all the things that we're seeing that makes us think maybe inflation is a concern in the stagflationary context. And I think that a good place to start with that is just going over what the most recent data is.

We just had the most recent CPI print come out the other day, and that showed core CPI increasing at 2.8% year over year. Now, that's up from 2.5% from the prior month, so core CPI is accelerating a little.

Joe: On the headline front, headline CPI, which includes the more volatile components of food and energy prices, we saw that increase at 3.8% year over year in the most recent period, and that's up from 3.3% in the prior month.

Diving into that a little bit more granularly, the energy component of headline inflation saw 17.9% year over year increase, which is huge. And for a little bit of consumer context, the national average gas price for AAA was quoted at about $4.51 as of this recording. And on top of that, we got a round of producer price information- and that showed a 6% year over year increase.

And producer prices, or PPI, that's often seen as a bit of a leading indicator for CPI, and so we'll see if that actually comes to be and if that leads to higher CPI numbers in the future. and we talked about this in a historical context, but it's important to circle back to it right now, and this all comes back to the fact that oil's a universal input.

Andrew, you were talking about all the different components that oil touches, so can we just kinda put that into modern day context?

Andrew: Yeah. There is a concern, right? Why should we-- What else could make us more concerned? Obviously, Hormuz is the big oil, our universal input. Most of that isn't coming to the US, but oil does get priced globally. We, I saw some charts, obviously, there's going to be US negotiations with China and how this plays out.

But, big impacts on some of our partners like South Korea and Japan, not to mention a lot of fertilizer comes through the Strait of Hormuz. The longer this goes on, the more we'll talk about stagflation. I think you could draw a direct correlation there. At least inflation, as this continues to persist.

The one thing I would add for this is a concern, this is the supply shock. The demand side, if the supply issues continue, doesn't improve the situation. barring a recession, which would trigger a return to some equilibrium. Otherwise, demand numbers are indicating that just out of AI alone, data center energy use will double by 2030.

and the data centers are coming, and the utilization is just increasing month over month So I would add that from the industry by itself.

Andrew: Yeah, I would add that alone from the demand side.

Joe: And to your point about it really depends how long this thing drags out. I think that it's important to note that the best case scenario at this point in time is, let's say the Strait of Hormuz opens today or tomorrow. It's still going to take a long time for oil supplies to normalize.

I don't know if anybody is familiar with how quickly oil tankers travel on the ocean, but the average oil tanker only travels at about 14 to 20 miles per hour. Now, I don't know about everybody else, but when I'm driving 20 miles per hour through a school zone, it feels incredibly slow, so I can't imagine what that would feel like crossing an ocean for hundreds or thousands of miles.

So there's going to be a lag effect. So even if oil's, even if the shipping situation resolves itself -

Joe: the actual impact is still going to carry on for a little bit longer into the future. There's also going to be a lagged impact with the agricultural component. Said that oil is a key input for a lot of fertilizers, and so we have a lot of farmers in the US who have been paying heightened prices for fertilizer, at, in this season.

But that's not going to really show up in inflation until later this year when the harvest is completed and we actually... and those farmers actually go to sell the product that they're currently planting. So there's a lot of reasons to think that even if things clear up in the near term, it's really hard to tell what the intermediate term impacts are going to be as those impacts start or continue to trickle through the economy.

Andrew: the economy. And what about Joe on the inflation may not be a concern? What are we thinking about there?

Joe: So I think a big part of it, again, we have hope that this Strait of Hormuz issue could clear up quickly, and, the faster it'll open, the less of a long-term impact it'll have. So that is still to be seen. As of right now, I think one of the key things I'm paying attention to from a positive side is inflation expectations, 'cause we talked about how important that is, and it's almost more important than the actual data that we're seeing because it informs actual consumer behavior.

And as of right now, inflation expectations are remaining relatively in check. We have one-year inflation expectations around 3.3%, two-year expectations around 2.8%, and five-year inflation expectations around 2.5%. So still above what the Fed wants to see, but we see it declining over time, so it's not entirely out of hand, and those inflation expectations are remaining relatively anchored.

Andrew: anchored. and where-- the inflation expectation numbers you're quoting, is that based on just forward, forward curve, forward rates, inflation swap rate?

Joe: Yeah. it's an implied expectation, between, US Treasury yields and Treasury inflation-protected securities. but essentially it's, how much-- it, it takes a-- it gives a sense of how much people are willing to pay for additional inflation protection, and out of that, we get what the actual inflation expectations are over those various periods of time.

Andrew: Yeah. I-- and I've seen those numbers myself before, so thank you for clearing them up. But, sometimes you can just look at the Treasury yield curve, look at the 30 year, and it's oh, are people pricing in longer?

Joe: Right. still not seeing that. So you're right, like on the expectation side, the market's being very positive about this. I'll pivot a little bit to the disinflation story that people are saying, contributes to inflation not being a concern long term. Again, it comes back to the AI story, the disinflationary effects of technology.

Andrew: We've seen this throughout history. I always give the boring television example, $200 for a big box TV that's scrambled in black and white, 40 years ago, $200 for a flat screen LCD TV, crystal liquid display, fancy stuff. Same price, but you get more out of it, right?

And those are disinflationary effects. I, everyone's talking about how that will come in AI, whether it's in crop yields, whether it's simply in labor and wage inflation. But I am a, I'm a bit of a believer in the disinflationary effects, but I think they'll certainly take longer to see than the current inflationary effects, and we might have a little bit of a timing issue.

There's no reason that you couldn't have a period of stagflation before recognizing disinflation. Yeah.

Joe: To be seen how that plays out, but at least from a narrative standpoint, it's quite compelling, I'd say. So I hold out hope that will be what we realize. Another piece I want to touch on is just the amount of energy that we use per unit of economic output these days versus in the '60s and '70s, and we're going to refer to that as energy intensity.

And current data shows that relative to history, we are currently using much less energy for each unit of economic output, and that's happening on the global level, the national level for the US, and on the individual consumer level. So even if we're worried about energy prices remaining elevated, we're at least slightly more insulated from that impact than we were in the past just because it takes less energy to produce more at this point in time.

Andrew: Yeah. A great example of productivity.

Joe: And to wrap this inflation piece up, I don't know, did you want to touch on US dollar dominance?

Andrew: Yeah. You can't ignore that, right? At the end of the day, we talk about oil being the number one input, or the, highest demand commodity, but we feel less inflationary effects than the rest of the globe, right?

We might feel the purchasing power domestically, struggles here and of course, but on a relative basis compared to the best-- the rest of the world, we are always in a better position, at least for now. May-- we'll see where the chips fall with the poor news. But so long as the US dollar is the number one currency in demand, you need that currency before you buy those commodities or trade in those commodities.

Then people have to buy dollars before they buy oil and before they buy corn and before they buy the next thing, which creates a natural demand for US dollars. And that's why we're able to push this monetarist system forward. And, a lot of the war will have to do with that and how trade deals cut after this.

But the continued use of the US dollar and there really being no strong competitor makes us in a better position, again, on a relative basis.

Joe: Yeah, so we could see some global struggles, but at least that could still point to US outperformance. Even if it might be a negative performance, it's a less negative performance. So that's something to give us a little bit of hope. But I think now's a good time. Let's move on to the stagnation piece of the puzzle, and that means low economic growth.

So the most recent reading has real GDP growth around 2% in the US. So let's dive into what we're seeing that points to some potential concern on the economic growth side. And from my perspective, the big thing that stands out is even though the most recent reading was pretty solid, it's-- we've been on a choppy road.

We've had some choppy economic growth, with an overall downward trend since roughly the end of 2021, and we even saw a negative GDP print in Q1 of 2025. So it's not out of the realm of possibility that we could see that again at some point in the near term future.

Andrew: No, not out of the realm of possibilities at all. I think you want to talk about maybe this K-shaped economy that we're having as well, how... And it's real. I hate some of the jargon sometimes, but when you look at the bottom half of the K, that's the m- where bulk of this, of, spending comes from.

Does that tail off?

Joe: Yeah. And kind of tying into the K-shaped economy and this bifurcation of experience within the same aggregate economy, that just brings us to the question of what is the quality of a GDP number? Even if it's a solid number at face value, we kinda have to look under the surface and realize, all right, GDP just shows what economic growth is, but is it high quality economic growth?

And I know these days a lot of people are thinking about the AI component of that. And I think most recent estimates say that Q1 2026 GDP, again, 2% number, estimates about 65 to 75% of that economic growth is attributable to corporate spending on AI build-out CapEx.

Andrew: Yeah, and this is where I'll say, I'm going to advocate for the not so concerned side of the equation.

I'm a big proponent of that story in the sense that I believe that it is real growth. So if we think about stagflation, high inflation, low growth has to be a part of those components. Again, it could be a relative metric. I'm going to be a relative right now. Growing up in this industry post '08 and seeing a decade of no real growth and low interest rates, and of course, all this capital was coming to encourage people to take risks, invest and try to figure out things like AI.

That period, while rates were low and all this money was being pushed in, had no real growth. Companies were buying back stock. CapEx was muted. They're, now you have a different regime. Yeah, rates are different. Let's put that aside. These companies, the largest companies in America, most of them being bigger than most countries, have finally taken their hands off the wheel and said, "We need to spend this money.

We need to invest this capital." And why is that? It's because of AI, and it's because they need to compete. Competition is the driver of economic growth, and to have these companies competing at AI, there'll be winners and losers, is positive for growth and spending. The velocity of money is starting to pick up.

And as they spend that money at the warehouse, at the, with the real estate agent and, on the power and with the electrician, that person puts it into their bank account and they spend it. So this is spending, a part of the economy which didn't see a lot of spending in a period where we thought these were the good years.

But I'm going to make a little bit of an argument to see this kind of spending and say, "This is what we want for our economy," and this CapEx is very exciting.

Joe: It’s definitely understandable that a lot of people are somewhat disillusioned by this massive amount of AI spending, but I think that's more of a concern when you're just thinking of AI spending as this abstract thing that you're detached from. But to your point, it's real economic activity.

There's real industrial materials being purchased. There's real factories, production happening, people being put to work to build these data centers, so that really does feed through into the real economy. Whether or not this all ends up being fruitful is still to be seen, but it's certainly worth holding out hope that things will pan out positively on that front.

Joe: I think, let's move on to the labor market side of things, if that sounds good to you.

Andrew: Yeah.

Joe: So again, starting with the current data, most recent labor data shows the unemployment rate at 4.3%, and the most recent reading for additions to non-farm payrolls showed 115,000 jobs added. If we're looking over the most recent two periods, it's doing even better.

Non-farm payrolls saw an increase of 150,000 jobs on average over the last two periods. But let's start with what we're seeing in the labor market that could point to potential concerns. And even though I just went over how solid the most recent non-farm payroll numbers were, it's another instance where we've seen some choppy numbers on that front.

And we had earlier periods where there were a handful of negative periods, so jobs were being taken out of the economy in a given month. And there's also been a slew of downward revisions. So even though the most recent numbers are solid, we don't identify trends based on individual data points. So there's still some lingering concerns on that front.

Andrew: Yeah. And I would add that there is a concern for labor, and if I had to pick between the three inflation, growth, and labor, I think it's labor that's going to give us the biggest unknown or the biggest variable.

Just like we, in similar respects, parallels the post-World War II labor supply problem, not, not the same here, but the labor environment changed, and AI is going to change the labor environment. It might even change economic theory down to the degree of how we consider adding the next individual person, a unit of labor or a machine, or how productivity gains should be considered in trade-off for actually employing someone.

And that, we're just at the beginning of that. The concern would be what? The concern would be that we don't get the proto- productivity gains that make up for the labor losses. I don't know. I don't know where that will fall, but that is the concern you're looking at. Yeah. And even though, Yeah.

Joe: I like hearing a lot of your positive narratives around AI, it is refreshing to hear that there is a little bit of doubt in your head. So it's important to, again, maintain that balanced perspective.

Andrew: Maintain that level of respect.

Yeah, this will come down to CEO decisions. Who can control whether a CEO fires or lays people off or forgoes hiring because he thinks he's getting good use out of AI?

Joe: To be seen. But let's pivot to, all right, what's, what are we seeing that makes us feel that the labor market might not be too much of a concern moving forward? And again, circling back to current data isn't that bad. Unemployment rate is remaining in check. We just had solid additions to non-farm payrolls, and claims for unemployment insurance are remaining pretty much in check.

So that's all positive in my view.

Yeah. it certainly isn't alarmingly concerning. I would consider the numbers to still be at full employment. AI will create new jobs that we haven't even thought of yet as well. I think maybe if I made one more parallel back to history, I know we're, we're-- this might be a little off topic in how we're proceeding here, but you mentioned Professor Siegel earlier with the policy missteps.

If I had to say maybe there was a policy misstep here as it relates to labor employment and AI, it could have been during COVID. That might have been the time period where we just put too much of this monetarist hat on. I don't even think Friedman would have advocated for as much QE as we had done, but we didn't allow the market to clear, and by the market the labor market.

All these retail employees, had they lost their jobs, unfortunately, and no one wants people to lose their jobs, but had that happened in 2020, we would be six years ahead of retraining the workforce for an AI world And the labor productivity change that is about to happen, the concern would be that we're not prepared for that.

Are we seeing it in the data yet? I don't think so.

Joe: All right, now let's switch gears and look at the consumer front, which is definitely tied into both the labor piece and the economic output piece. As of right now, I'd say that the main thing pointing to concern on the consumer front is consumer sentiment. It has been in the dumpster lately.

Andrew: Yeah. Sentiments dropped off a cliff. I think the numbers were nearly 70 last year, starting off 2025, a reading of around 70, and, that might not sound like anything, but today that plummeted below 50.

you have a delta of, over 20, 25, 30% of a drop-off in, in consumer sentiment. It's a survey. It's a hard number to understand. sentiment is gauged by the responses for those surveys. Do people actually act and spend the way that they say? or, do they say one thing and do another?

Right now they are, but that doesn't mean that it might not change. You do need to take sentiment into consideration. It just doesn't seem like people are weighing it too heavily right now.

Joe: Yeah, take it with a grain of salt. We don't inform monetary policy based on vibes, so we'll wait to see if those vibes feed through to actual economic activity.

Andrew: We'll see if the vibes check out.

Joe: And even, I guess on the positive side or like a way that we can frame consumer sentiment in a less negative sense is the fact that in the post-COVID era, it seems like we're just in an overall deflated sentiment environment. So who's to say whether the current readings are just a, a, an ongoing impact from what we experienced during COVID, or if it's actually responding to what we're seeing here and now.

All we know is, all right, once COVID showed up, sentiment, like you said, jumped off a cliff, and it's gone down more since then. But who's to say where the neutral level is in this post-COVID world?

Andrew: Yeah. Very hard to say.

Joe: And last thing I want to wrap up with in this section is the positive sides of-- or, a few additional positive points as to why we think that we might be able to avoid a stagflationary environment even given current conditions. And that comes back to the higher level of experience that our policymakers have with this monetary regime.

As we highlighted in the historical piece, they were in a new monetary regime where the Bretton Woods Agreement and the gold standard broke down, and they didn't know how to navigate that environment. But luckily, I can say that we are still operating within that monetary framework to this day, and we have decades of history to look back on and to inform our decisions moving forward.

And on top of that, our quality of data is so much higher. I can't imagine what the data collection process looked like for Federal Reserve officials back in the '60s and '70s, but at least now we know that we have computers with information traveling at the speed of light, so our policymakers are much more thoroughly informed than they have been in the past.

Andrew: That's a good point. Yeah. The-- That is a very good point in terms of being able to react quicker. We certainly saw that, with Bernanke, and we certainly saw it in COVID even quicker with Powell and the reaction there,

Joe: All right. We are going to change lanes here and dive into what are the actual portfolio management implications of the topic of stagflation. And as we've said a few times, stagflation is not our base case assumption. It's not a prediction that we're making. But for the purpose of this upcoming section, we're going to discuss investment decisions as if stagflation is afoot.

And I want to start by looking at, all right, if we find ourselves in a period of stagflation Where do the biggest risks lie? And I think one of the ones that jumps out at me, Andrew, is we would definitely expect a breakdown in traditional correlations between different asset classes.

Andrew: Yeah. This is where it gets tricky, and we saw a little bit of this in 2022 with the movement up in interest rates. But in environments like this, you could see correlations break down entirely, or in other words, in down markets, correlations all move to one, meaning that everything just starts moving down.

Where-- How does that work if we get more specific in stocks and bonds? It's the inflation side that's bad for bonds. You're getting a fixed coupon. Maybe that coupon is 4% or 5%, but you have inflation of 4% and 5% really just withering away your real return, and you're locked into that coupon payment for the duration of the bond.

So there's a risk there. On the other side, for stocks, that's the stagnation side. Limited growth might mean limited income, limited earnings, right? Could mean... and that could differ by sector and industry and company, so there could be positives and negatives among there. But by and large, if we were looking at a period of stagnation, there are certainly going to be some companies that struggle to adjust, whether it be, passing on prices to consumers or not, or just whether their costs are unsustainable.

Joe: All right. And if we're looking at the specific characteristics of different investments and how those might be impacted by a stagflationary period, what are some of those investment characteristics that you would say maybe we steer clear of those, in a stagflationary environment?

Andrew: Yeah. What's that famous kind of phrase?

Carbs are the enemy? Like here, duration is the enemy, right? So let's talk about bonds again. We talked about, if you're stuck into a coupon payment under an infla- inflationary environment, you're effectively withering away your real return. The longer that goes on, the longer you're locked into that bond, the longer its duration, the worse of a scenario you're in.

So also, if we're just going to do the quick bond math, as bond... as rates go up, bond prices go down. The longer your duration, the more rates go up, the more your prices go down. That's the way bonds work. On the stock side, you do have a duration mismatch as well, right? Stocks are naturally long-duration assets.

They're perpetual instruments. preferred stocks being among the, would get hit the hardest because they effectively work like a bond with no maturity. But common stock also perpetual, and in here, again, we mentioned, it'll, differ by company, but if we think about putting these into different groups like growth and value, it's on the growth side where you're expecting cash flows to come later because the company is probably investing right now or, trying to get off the ground, whatever that might be.

But longer duration periods for recognizing income or growth companies which are in their early stages have a bit more risk. They tend to gap down in multiples, right? We invest in, in growth with high multiples, and if rates stay higher, it becomes quite easy for multiples to contract and contract pretty quickly.

So be careful with long-duration growth.

Joe: And how about on the credit quality side of things? I think it probably seems pretty obvious that if we found ourselves in a stagflationary environment or really any environment of distress, the issuers with lower credit quality would probably be worse off, right?

Andrew: probably be worse off, right? Yeah. Credit during an extended inflationary or stagflationary environment, let's be specific here, you want to be very careful. One, limited growth, limited income, limited spending. These companies are already of lower quality. You might see them hit the impact there first, in terms of, decline in earnings, inability to pay their debts.

But there's another element to this. It's the ability to refinance debts. High-yield, debt, typically in the medium-term range, five years or so- You know, the longer higher rates persist, if they're relying on refinancing to kinda sure up the balance sheet, they're not going to be able to do it at lower rates.

And high yield is going to get hit the hardest from that, if they can't get back to capital markets.

Joe: Or even of refinancing, a lot of those lower credit quality issuers have to rely on floating rate debt. So obviously they would, they'd be up, up the river without a paddle in that case.

Andrew: Even worse, yeah.

Joe: So how about from a sector standpoint? If we found ourselves in a stagflationary environment, which sectors do you think would be most sensitive?

Andrew: From a sensitive side, you have to look right to consumer discretionary. If the consumer is under trouble and you see those em- unemployment numbers going up, you're seeing spending come, tail off, certainly consumer discretionary is one to be concerned with.

I think banking, traditional, banking in terms of, your regionals and, your smaller commercial banks, there's some worry there. banks need an upward sloping yield curve, especially if they don't have an investment bank or an asset management department and it's traditional, deposits and lending.

They need a positively sloped yield curve, to operate their business as well. Right now with the move up i- in inflation, you're starting to see the yield curve flatten out, and that could be painful for banks.

Joe: what would it be-- what would we be looking towards if we're trying to find some corners of the market that might be, I don't want to say that they'd perform well in a stagflationary environment, but at least are a bit more insulated from the impacts of stagflation? What areas would you be looking at?

Andrew: at? If you're thinking about the alternatives bucket, you could look at the commodity space, right? And, we don't do any hard asset, direct commodity investing, but commodities as a sector might be somewhere you're starting to look.

be careful there though. These are prices that are driven by volatility in many instances by big geopolitical players. But if we were going to look a little bit more traditionally in, in the equity space, obviously the energy companies are a great place to look at who can benefit from energy and price increases here.

Materials companies who are mining these materials are also probably a place that will do well. The struggle though is that these have become such small parts, of the index that to make that decision, if you were going to say, "Oh, I, want to sure up some capital here because of stagflation," any overweighting there is a pretty active bet, especially in something like materials, which is 1% or 2% of the S&P.

Joe: And that kind of brings us, it's a good segue into the next piece of the conversation, which is what portfolio actions would we recommend, either if we find ourselves in a stagflationary environment or if we're anticipating a stagflationary environment? And I think that the key takeaway is that we do not recommend aiming to optimize your portfolio for a stagflationary environment, because it's one thing if we do, find ourselves in a stagflationary environment and your choices pan out well, but there's also the very real possibility that we do not see stagflation and those choices that you made to optimize for that environment would end up giving you a, world of trouble at that point in time.

Andrew: Yeah, look, we take a very globally diversified approach, and I think, being measured and having a plan, sticking to that plan is always the best way, within the context of a client's risk tolerance and objectives is something you want to stick to.

And I think the takeaway from a portfolio management perspective in this conversation is stagflation's going to start hitting your television screens a lot more. None of us have lived through a stagflationary environment. I'm sure... Actually, excuse me, I'm sure there's some advisors on the call who have.

A lot of us haven't. I had to reach into the back of the closet and dust off the CFA books. But I think a large takeaway is don't see stagflation and think you need to react in your portfolio because the risk of adjusting a portfolio, taking these, taking positions or overweighting what might benefit from stagflation, and stagflation being such a relative measure, so many mo- moving components, that trying to position the portfolio for that is a bigger risk than just main- maintaining a globally, diversified portfolio and, being patient.

Joe: And that's not to say that there's no action to be taken with some investors' portfolios, but yeah, I think it comes back to, prevailing portfolio management principles that will apply regardless of whether stagflation is afoot. That comes back to those risks that we highlighted, long duration, low credit quality.

Are you overexposed to those areas, and is there room to trim that risk? But again, that's not really-- It's a good thing to consider in the context of our conversation around stagflation, but it's something that should be considered in every portfolio management conversation.

Andrew: Yeah, I always think about risk first, and with stagflation, avoiding the risk is certainly, top of mind, and so I think you've summed that up well.

Joe: And if we do find ourselves in a stagflation environment, here at Balance PM, we like to look for the silver linings. And if we can offer one, I'd say, hey, maybe take it as an opportunity to rebalance your portfolio if you need to. And also, if you have clients that are interested in tax loss harvesting, that might be one of the most notable opportunities to harvest losses that we've seen in quite some time.

So I always gotta look at the positive side, right?

Andrew: Yeah. I love you finding optimism in the down market. You have to, 'cause we- we're going to have to live through them someday.

Joe: But now I want to just kinda wrap everything up in a nice little bow and give people a summary of what we discussed around stagflation and kinda how we view the conversation around stagflation. And it starts with the fact that we do not know if stagflation is around the corner. There are certainly some historical parallels and current warning signs that we'll be keeping our eyes on. But there are also plenty of off-ramps that could help us avoid it.

So regardless of what you think is in store for the economy, it's our view that portfolios should not be adjusted to assume one way or the other, whether stagflation is imminent or avoidable. Instead, we advocate for a balanced approach where you simply try to trim any excessive exposure to areas of the market that may be more sensitive to stagflation.

And as always, aim for a well-diversified, all-weather portfolio that lets you and your clients sleep well through a range of economic environments. And I think that is a great place to wrap up this episode, Andrew.

Andrew: Yeah. Joe, you couldn't have said it better. Thank you, Joe. I want to thank everyone in our wonderful production team behind the scenes, putting a lot of work into this. And thank you to everybody for tuning in to our first episode of "Balance PM."

I've been so excited about this and for more episodes. For everyone that joined us who is a part of the network and using our platforms, we're going to put a stagflation watch dashboard into your Y charts with some of the economic data points we talked about here. This way we can just keep an eye on them and measure them over time.

So thank you everyone for joining. And Joe, thanks again, man.

Joe: Thanks, Andrew. Everybody, enjoy the rest of your day.