Is the U.S. economy headed for 1970s-style stagflation—the dreaded combination of economic stasis and high inflation, characterized by soaring consumer prices and interest rates and high unemployment?

“Investors may be underestimating the risk of a return to 1970s stagflation,” Michael Arone, managing director and chief investment strategist of State Steet SPDR ETFs, argued in an analyst note.

While an economic soft landing has overwhelmingly become bullish investors’ consensus outlook, thanks to the S&P 500’s new heights driven essentially by a handful of companies, Arone said he is troubled by what he calls a “puzzling economic picture.”

“It’s the decelerating trend in annual GDP growth that may be most alarming. The surprisingly strong pace of U.S. economic growth is expected to cool considerably before year’s end,” he said.

On February 21, Bloomberg economists forecast annual U.S. GDP growth would slip to 1.4% for all of 2024, down from 4.9% in the third quarter and 3.3% in the fourth quarter of 2023. That estimate undercuts the latest Federal Reserve Bank of Atlanta forecast of 2.9% in the first quarter of 2024. 

Another area of concern is inflation, Arone said.

“The threat of resurgent inflation might be the biggest reason investors should fear a potential stagflation outcome,” he said.

Both the Consumer Price Index (CPI) and Producer Price Index (PPI) came in hotter than expected, he said. The data temporarily sent stocks reeling and Treasury yields surging. Market participants were forced to reduce the number of expected Fed rate cuts this year, as well as push the timing of the first cut further out in 2024, Arone said.

To track actual inflation, sell-side analysts Strategas Research Partners created its own “Common Man CPI,” which includes must-have items such as food, energy, shelter, clothing, insurance, and utilities.

The Common Man CPI rose 3.3% year-over-year, greater than the headline CPI figure of 3.1%, Perhaps more importantly, the Common Man CPI has grown faster than wages over the past five years, Arone said. 

“Using Strategas’ inflation measure, people may already be suffering from some form of stagflation," he said. "That might help explain why the Biden administration is polling so poorly on the economy despite record low unemployment and all-time high asset prices."

Strategas is also predicting that a second wave of U.S. inflation starts on average 30 months after the first peak. The US is 19 months past the June 2022 peak in CPI.

“This inflation data suggests that stagflation could shock the economy in the next 12 months or so,” Arone said.

Arone's arguments echo those of J.P. Morgan chief market strategist Marko Kolanovic earlier this week.

Kolanovic said that the economy may turn away from a "Goldilocks" scenario—where growth flattens—and enter a period of stagflation similar to that experienced in the 1970s.

"There is a risk of the narrative turning back from Goldilocks towards something like 1970s stagflation, with significant implications for asset allocation," Kolanovic said. 

Stagflation ravaged the U.S. economy in the 1970s and early 1980s, when gas prices soared and rising prices pushed the CPI as high as 14.8%. The Federal Reserve hiked interest rates to nearly 20% that year. 

"There are many similarities to the current times," Kolanovic added. "We already had one wave of inflation, and questions started to appear whether a second wave can be avoided if policies and geopolitical developments stay on this course."

With Fed officials making it clear that they intend to delay interest rate cuts, “investors should be open-minded that there is a scenario in which rates need to stay higher for longer, and the Fed may need to tighten financial conditions," he warned.

Arone agreed that with the pace of economic growth moderating, restrictive Fed monetary policy will continue to cool the economy.

Arone said that “extraordinary government spending has produced inflation and enormous deficits. Structural supply-demand imbalances in the housing and labor markets are contributing to inflationary pressures. The multi-decade transition from fossil fuels to cleaner energy has been surprisingly inflationary. Deglobalization, protectionism, and geopolitical conflicts might also curb global economic growth while stoking inflation. And, more often, there are multiple waves of inflation."

Arone said investors need to deal with the stagflation risk by diversifying.

“A diversified investment allocation to real assets, including gold, may help to ease the pain from a stagflation outcome,” he said.