Amid continued Iran tension, is the stagflation threat really that scary?

As we enter week six of the Iran conflict, the Strait of Hormuz problem remains the primary economic overhang.

The big questions we’re answering for clients right now: Will this closure drive a permanent spike in inflation? Is a global growth slowdown inevitable? And ultimately, are we looking at a legitimate risk of stagflation?"

Here’s the answer you likely haven’t heard: A slower-growth, higher-inflation environment might not be as bad as you think—and could even lead to specific opportunities.

Inflation in context

It’s true, the current inflation picture isn’t great. Just a few days ago, Fidelity’s Asset Allocation Research team made the case that inflation is more likely to run higher than the current market consensus. Reasons include (1) past energy supply shocks having been multi-month events, (2) secondary waves of inflation following a peak (like the one in 2022) have been common, and (3) the team issuing an increased number of inflationary signals.

The team thinks CPI inflation could rise toward 4% over the next 9 to 12 months. In comparison, market expectations based on inflation swaps call for an inflation rate closer to 3% over the same period (Exhibit 1).

Sounds bad, right? Does this mean we are going to see a repeat of the 1970s all over again? If so, what does that mean for bonds?

Reasons to discount some of the worst fears:

1. The 1970s provide many specious comparisons. (A) The U.S. economy is far less oil intensive than 50 years ago, (B) Energy independence and strategic reserves provide limited buffers that didn’t exist in the 1970s. We have positive economic productivity with historically low unemployment today, versus negative productivity and high unemployment back then.
2. While the near-term inflation environment is less than ideal, TIPS inflation breakeven rates suggest they could fall back to more acceptable levels over the next five years and beyond.
3. As of early April, Fed funds futures reflect an anticipated 8-basis-point increase. Given that the Fed adjusts rates in 25-basis-point increments, we interpret this pricing as a signal that rates will remain unchanged. However, the Fed remains data-dependent, and should economic conditions shift, we could even see the easing cycle commence in 2027.
4. As our team has noted before, stagflation can be explained by the Misery Index (unemployment + inflation). Today's Misery Index of ~6.9% stands in stark contrast to the 20%+ levels seen nearly 50 years ago, suggesting “stagflation-light” is a more accurate descriptor than a 1970s redux.

Implications and realities for the bond market

Our base case is that bonds continue to offer income diversification benefits for equity investors, driven by attractive yields and valuations roughly in line with long-term averages.

Could we be wrong? It would be problematic if the Fed were forced to raise rates this year, or if 10-year U.S. Treasury yields broke out solidly above 4.5%.

Yet we don’t see either as a base case.

Here’s what we’re watching:

1. Weekly data going back to 2022–2023 reflect a giant consolidation pattern for 10-year U.S. Treasury yields. Which way will it break, higher or lower? It could go either way, although our technical analysts lean toward an eventual downside move. Peak oil prices and the Middle East ceasefire each may remove some market uncertainty and encourage a move lower for yields as well. If yields did move lower out of the sideways range, it would be positive for bond prices (as they move opposite yields).
2. Spreads have widened year-to-date because of conflict with Iran. Nothing is necessarily cheap, although our team sees idiosyncratic opportunities.
3. Meanwhile, the combination of historically low compensation, rising U.S. indebtedness, and longer-term rate uncertainty brings risks further out the yield curve.

The potential opportunity:

In this environment, it’s all about getting rewarded for taking risks. Considerations, therefore, include investments at the shorter end of the yield curve and several unique bond asset classes.

These include:

1. Limited-term bonds, which focus on investments with durations in the one-to-five-year range, often focusing on two to a little beyond three years. Yields are competitive, and should interest rates decline, these strategies may experience capital gains. If yields do rise, we think investors are likely less exposed to price declines relative to longer-dated securities.
2. AAA CLO ETFs, which offer compelling yields relative to duration and can benefit from floating-rate coupons, which can help insulate investors from interest-rate volatility. CLOs feature several layers of defense, including seniority in the capital structure, diversification across hundreds of loans, and limits on lower-quality holdings.
3. Convertible bonds. This market has been driven by supply and demand dynamics. Roughly a third of the convertible market is set to mature in the next few years, creating the potential for pent-up demand that could provide a tailwind for prices. The opportunities appear idiosyncratic, favoring active management in this highly inefficient asset class.

Conclusion:

Advisors cannot forget about the importance of clients maintaining exposure to fixed income, even in a slower-growth, higher-inflation environment.

While inflation needs to be monitored, market pricing suggests inflation expectations could stay contained. Meanwhile, bond valuations are best described as “OK.”

Positioning emphasizes being selective and intentional, favoring areas of the bond market where investors are more clearly compensated for risk—particularly at the shorter end of the curve and in asset classes with structural or technical support.

This approach allows portfolios to remain resilient, even if growth and inflation dynamics in the future are not ideal.

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