Will stagflation end the bull market?

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Source: Jinjin Investment Research

Recently, global stock and commodity markets have experienced intense volatility, primarily due to the worsening Middle East situation. From a purely investment perspective, this geopolitical conflict itself isn’t that frightening—just a quick review of history shows that most conflicts don’t alter the market’s fundamental trend. For example, the Russia-Ukraine war has been ongoing for years, with a much larger scale than the US-Iran conflict, yet it hasn’t prevented global economic and market prosperity.

However, this time is different because the conflict has attacked a crucial component of the global economy: oil prices. Although Iran’s oil production is less than half of Russia’s and its reserves are far fewer than Venezuela’s, its impact on oil prices is much greater than the main protagonists in the previous conflicts. The key reason is Iran controls the vital chokepoint for global oil transportation—the Strait of Hormuz.

The Strait of Hormuz handles about 14-15 million barrels of crude oil daily, accounting for 31% of global oil shipping. Over 90% of oil exports from the Middle East Gulf region pass through here. In early March, Iran announced a “selective blockade” of the strait, causing transportation volumes to plummet by 90%, even temporarily halting navigation. Disruption of Middle Eastern oil exports directly triggered a surge in oil prices, which jumped from around $70 to over $100 within a month and a half, peaking near $120.

As the most vital energy source for economic development, oil isn’t an isolated commodity but a macro variable influencing the entire economy. The immediate effect is a sharp rise in global inflation risk, which can trigger a series of negative reactions, most notably delaying the Federal Reserve’s rate cuts. Therefore, at the recent Federal Open Market Committee (FOMC) meeting, the Fed became noticeably more hawkish—no rate cuts were announced, and expectations for rate cuts this year significantly weakened. For the first time, discussions about possible rate hikes were openly aired, leading to a sharp decline in global markets, including the A-shares.

Members who frequently attend our courses might ask: Isn’t rising inflation a good thing? According to our macro cycle theory, inflation is the most important variable affecting stock market fundamentals because it reflects the supply-demand balance of the real economy and directly determines corporate profits. Generally, if inflation rises, it indicates the economy is overheating with demand outstripping supply, which tends to improve corporate earnings—definitely a positive for stocks. So, we have said that only when inflation reverses and starts rising again will the A-shares shift from a valuation-driven bull market to a profit-driven real bull market.

But why has recent inflation, which is clearly rising, become a negative? This requires understanding the underlying mechanism of inflation.

Inflation is fundamentally determined by supply and demand in the real economy. Deflation means supply exceeds demand, leading to excess capacity. Conversely, rising inflation means demand exceeds supply, causing shortages. Specifically, based on the causes of output gaps, inflation can be driven by two scenarios: demand-pull inflation, where supply remains relatively stable but demand significantly expands, and cost-push inflation, where demand remains unchanged but supply shrinks sharply, and production costs rise, passively pushing prices up. This often results from shortages of key production factors, such as recent oil supply crises or labor and material shortages during the pandemic.

Both types of inflation lead to output gaps with shortages, but they have very different implications for the economy and markets.

The first type—demand-pull inflation—is healthy and definitely beneficial for the economy and markets. It indicates strong economic recovery, with demand outstripping supply in the real sector, prompting producers to raise prices proactively. Consumers’ incomes increase, making them willing to pay higher prices, leading to higher sales and profits for companies. Additionally, as people have more money and risk appetite rises, potential investment funds in the stock market increase, boosting valuations.

For example, the inflation in the US over the past few years post-pandemic was driven by such demand-pull factors. The US adopted aggressive monetary easing and fiscal stimulus policies, causing inflation to soar to multi-decade highs. Behind this was a robust economic rebound, significant increases in per capita income, and strong consumer demand, which led to rising inflation. Corporate profits improved notably, and with investors holding more money and higher risk appetite, the US stock market experienced a major bull run driven by both earnings and valuations.

Similarly, in China, from late 2020 to 2021, a demand-driven inflation cycle occurred. Under policy stimulus and the last surge in real estate, economic demand strengthened significantly, pushing inflation higher. Corporate profits improved markedly, investor enthusiasm surged, and the A-shares market experienced one of the strongest bull markets in nearly a decade.

The second type—cost-push inflation—is unhealthy and definitely negative for the economy and markets. It indicates significant shocks on the supply side, leading to passive supply contraction, rising costs, and inflation. This pushes the economy into a state of demand-supply imbalance without actual demand improvement, akin to an early onset of stagflation. It raises production costs, erodes profits, and increases consumers’ living expenses, reducing real income.

If demand remains strong, these issues are manageable because companies can pass costs onto consumers, who have higher incomes and can absorb price increases. This was evident in the US in recent years: despite soaring prices, incomes also rose quickly, allowing consumers to accept higher costs.

However, if demand is weak or declining, persistent high prices and falling real incomes can drag the economy into a stagflation scenario—weak growth combined with inflation—which severely harms corporate profits. Rising costs force companies to raise prices passively, potentially leading to shutdowns if costs can’t be covered. Consumers’ purchasing power shrinks, making products harder to sell, further eroding profits and demand, creating a vicious cycle.

The most awkward situation is that, amid high inflation, policies become constrained. Central banks and governments find it difficult to stimulate the economy through monetary easing or fiscal measures, and high inflation forces them to tighten instead, further dragging down demand and deepening the downturn—ultimately leading to recession. The stagflation of the 1970s is a classic example of this.