The markets are in the early stages of pricing in stagflation. Here's what happens next.

By Steve Goldstein

Defensive sectors will outperform if oil-price gains are sustained, say Citi analysts

Markets are starting to price in a stagflation situation.

There's been a month of stellar earnings - the fewest earnings misses in 25 years, apart from the pandemic recovery - and where basically nothing has happened in the Strait of Hormuz, with little kinetic action but also few ships traversing the key waterway.

Citi's team of quantitative analysts has studied the market and says it's beginning to smell like stagflation.

"We make the case that the current analog return patterns do rhyme with the early signs of a pricing of stagflation. Specifically, we find the simultaneous underperformance in both equities and bonds often precede the official trigger of the stagflation regimes, while commodities take some time before being a useful stagflation hedge," say the strategists, led by Vinh Vo, a London-based analyst for Citi's quant global macro team.

The strategists studied four previous stagflation clusters: the mid-'70s "Great Inflation" episode, a subsequent shorter phase in the early 1980s, briefly in the global financial crisis and the post-2020 period. The key lesson, they say, is that markets will identify stagflation before economic indicators do.

What happens during stagflation? Bonds tend to absorb more of the initial shock either from the earlier sequencing of an inflationary boom or a tightening of financial conditions, but they also tend to stabilize comparatively sooner, the Citi strategists say. The stock-market deterioration is more gradual but also lags deeper into the tightening phase. Gold does not trade in line with its reputation as a stagflation hedge but instead - as has happened recently - can trade in line with other risky assets.

In the early days of stagflation, stocks and bonds can act more as an early warning sign than a contemporary indicator that stagflationary conditions are here.

So where are we right now? Based on a 22-day rolling correlation of market returns, the strategists say the market is moving from a more benign recovery/normal regime early in the year "toward a regime that looks much more like inflation boom and tighter financial conditions, i.e. the typical regime we see prior to stagflation."

Energy XLE has repriced the most, while bonds and equities have also moved in the expected direction of stagflation without fully pricing it in.

In a stagflation regime, energy stocks will perform the best, by sector, while financials XLF and industrials XLI struggle, the Citi team says. By factor, meanwhile, trend and momentum do well, as does quality, the strategists add.

The markets

U.S. stock futures (ES00) (NQ00) lurched lower after Iran said, in a disputed report, that it had hit a U.S. warship with missiles, though the subsequent U.S. denial took markets off lows. Crude-oil futures (CL00) still rose, however.

   Key asset performance                                                Last       5d      1m      YTD     1y 
   S&P 500                                                              7230.12    0.91%   9.84%   5.62%   27.14% 
   Nasdaq Composite                                                     25,114.44  1.12%   14.79%  8.06%   39.70% 
   10-year Treasury                                                     4.379      3.40    3.50    20.70   3.00 
   Gold                                                                 4559.5     -2.94%  -2.49%  5.25%   36.37% 
   Oil                                                                  105.06     8.67%   -6.70%  83.00%  83.58% 
   Data: MarketWatch. Treasury yields change expressed in basis points 

The buzz

U.S. Central Command announced it would help restore freedom of navigation for commercial shipping through the Strait of Hormuz. Iran threatened to attack any U.S. ship that entered the waterway.

Berkshire Hathaway (BRK.B) reported first-quarter growth in operating earnings of 18% and ended the quarter with $397 billion in cash.

GameStop (GME) made an audacious cash-and-stock offer to buy eBay (EBAY) for $56 billion. EBay said it would review the proposal.

Norwegian Cruise Line (NCLH) stock slumped after a profit warning, citing the war as well as revenue underperformance.

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The chart

Deutsche Bank analysts call the old adage "sell in May and go away" a myth, though their own calculations aren't quite as dismissive of the approach. A team of strategists led by Maximilian Uleer focused mostly on European equities but also crunched the numbers for the S&P 500. Since 1973, an investor who invested in U.S. Treasury securities during the summer months returned 12% per year, versus a buy-and-hold return of 10.4%. However, bailing out of stocks in the summer only outperformed in 22 out of 53 years. Last year would've been particularly disappointing - those seasonal investors would've missed a 14% run in stocks from May to September, a period when Treasurys returned 3%.

Top tickers

Here were the most active stock-market ticker symbols on MarketWatch as of 5 a.m. Eastern.

   Ticker  Security Name 
   GME     GameStop 
   NVDA    NVIDIA 
   TSLA    Tesla 
   AMZN    Amazon.com 
   TSM     Taiwan Semiconductor Manufacturing Co. 
   AMD     Advanced Micro Devices 
   EBAY    eBay 
   AAPL    Apple 
   MU      Micron Technology 
   MSFT    Microsoft 

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05-04-26 0812ET