Markets Weekly: The Stagflation Specter

JPMorgan Chase CEO Jamie Dimon has been a persistent voice warning of the risks of stagflation. In April last year, Dimon said “stagflation is on the list of possible things” that could happen to the US economy. He repeated the warning at an investment conference in September, saying that a toxic combination of slow growth and high inflation was "not off the table."

At the time, Dimon’s concerns were widely dismissed. Policymakers and market analysts largely downplayed the risk of stagflation, viewing it as an unlikely scenario. Federal Reserve Chair Jerome Powell, for instance, remarked during a press conference that he didn’t "see the stag or the -flation, actually." Similarly, Ian Shepherdson, chief economist at Pantheon Macroeconomics, argued that fears of stagflation should be "ignored", pointing to data that suggested a gradual softening of price pressures.

But just months later, Dimon’s warnings seem increasingly prescient. With President Trump's trade policies stoking inflationary pressures and key economic indicators flashing warning signs, the specter of stagflation looms larger.

Evidence of a growth slowdown is mounting, the most recent S&P Global PMI report revealed:

A key development evident in the February flash PMIs was a sharp slowing of business growth in the US, accompanied by rising goods prices. Companies widely blamed the weaker expansion to uncertainty and disruption caused by recent US government policy initiatives, while tariffs were widely cited as a key cause of higher prices in the manufacturing sector.

The report's US Composite Flash PMI Output Index, a measure of activity across both goods and services, fell to a 17-month low of 50.4. While readings above 50 technically indicate expansion, the sharp deceleration from the robust growth seen in late 2024 is alarming. S&P Global noted that this PMI reading is now "indicating just 0.6% annualized GDP growth in February," a significant drop from the 2.4% signal for the fourth quarter of 2024.

The US economic slowdown was particularly evident in its service sector, which shrank slightly and became the only one in the G4 nations to be doing so. This contraction in February marked the first downturn in US service activity in over two years.

Compounding these signs of a broader slowdown, unemployment claims also ticked up. First-time applications for unemployment benefits rose much more than expected last week, suggesting that cracks may be forming in the US labor market, a key indicator of economic health.

There were an estimated 242,000 jobless claims filed last week, according to data released by the Department of Labor. That’s an increase of 22,000 from the prior week’s tally, and is the largest weekly spike in claims in more than four months.

Simultaneously, inflation, far from being tamed, shows signs of remaining elevated, and even accelerating in some areas:

No matter what metric you’re looking at, US inflation is moving in the wrong direction again. Whether it’s a house or a carton of eggs, price growth is once again intensifying across a broad range of indicators. (Bloomberg)

Most worryingly, inflation expectations are rising:

Long-run inflation expectations — which look at the next five to 10 years — rose in February to the highest level since 1995, per data from the University of Michigan. Year-ahead expectations are elevated, too, which is dragging down measures of sentiment from the university and another from The Conference Board. (Bloomberg)

This rise in inflation expectations is a critical concern for the Federal Reserve, as expectations can become self-fulfilling prophecies. On Thursday, Kansas City Fed President Jeff Schmid said:

The last two months have seen a sharp upward movement in some measures of expected inflation. Certainly, survey measures of inflation expectations are imperfect and subject to noise, but with inflation just recently at a 40-year high, now is not the time to let down our guard.

The S&P Global PMI report provides further evidence of inflationary pressures, particularly in the manufacturing sector:

US manufacturers reported the highest selling price inflation for two years, and a pace now outstripping that seen in the other G4 economies, as input costs in the sector surged higher at a rate not seen since November 2022. Of those US manufacturers reporting higher input prices, over one-in-three directly attributed the rise to tariffs, with other producers ascribing the rise more generally to the new government's policies.

And this brings us to the central driver of the stagflation risk: President Trump's aggressive tariff policies. Just yesterday, Trump's announced yet another round of tariff:

US President Donald Trump said Thursday that a 10% additional tariff on imported goods from China will take effect on March 4 because drugs made there are still pouring into the country. (Nikkei Asia)

This additional tariff on Chinese goods, on top of existing duties, is likely to exacerbate inflationary pressures. Tariffs act as a tax on imports, raising costs for businesses and, ultimately, consumers. The combination of higher prices from tariffs and a slowing economy creates the classic stagflationary environment.

This puts the Federal Reserve in an extremely difficult position. Its dual mandate requires it to pursue both maximum employment and price stability. Stagflation forces a trade-off: raising rates to fight inflation could further slow growth and potentially trigger a recession, while cutting rates to stimulate growth could fuel inflation. Aiden Reiter of the Financial Times captured this dilemma:

...that puts the Fed right between the two sides of its mandate. If they have to cut in order to save the economy or save the labour market...then that would cause inflation to tick up again. Or they could, you know, keep rates where they are and watch the economy crumble while inflation only comes down a bit.

And Fed's Schmid reiterated their cautious stance:

I intend to keep my eye focused on inflation. I am not willing to take any chances when it comes to maintaining the Fed's credibility on inflation.

Stagflation, it seems, is no longer a distant threat.

Long / Short

AI Rally: "...recent earnings and capex plans from big tech companies suggest the global AI growth story remains intact. We expect 2025 capex from the Big 4 US tech firms to grow by 35% to USD 302bn, and we see ongoing strong demand for frontier models. With improving AI adoption trends boosting monetization, we expect mid-teens returns for global AI stocks this year using our market capitalization opportunity framework." (UBS)

Equities: "The first half of 2025 would likely be choppier for stocks than what we experienced through much of the fall of 2024... several reasons including the upside in yields that carried over into 2025. Since rates broke above 4.50% in mid-December, the S&P 500 has made no progress." (Morgan Stanley)

Crude Oil: "We have been forecasting a 70-85 range (for Brent) and we continue to stick to that range...we think this range is essentially what OPEC is aiming for. They have been defending 70 as a floor, and they’ve been signaling production increases when Brent was in the low to mid 80s. And then on the US side, there’s a lot of focus on the fact that President Trump wants to support energy affordability, which in our view means Brent below the mid 80s." (Goldman Sachs)

Quick Hits

• German Economic Concerns: The German economy shrank by 0.2% in Q4, and the Bundesbank suggests it could stagnate again this year, with corporate bosses urging quick action from a new government.
• Asian Central Banks Decoupling: A trend of Asian central banks decoupling from the Federal Reserve is emerging, marking a shift in monetary policy.
• Gold's Record Run: Gold prices are holding near record highs as the dollar weakens and investors focus on upcoming US inflation data.
• Cocoa Price Surge: Wild cocoa markets are pushing Europe's historic chocolatiers to the brink, with poor harvests in West Africa driving prices to record highs.
• China's Tariff Response: China vows "all necessary measures" against new US tariffs, which include a 10% levy set to begin on March 4.