Stock Market Rallies Are Under Threat of Stagflation. What Investors Should Know

Concerns about stagflation—a combination of persistent inflation and slowing economic growth—are resurfacing, and this time, investors are finding it harder to dismiss these worries.

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Over the past few years, stagflation fears have emerged periodically as inflation remained above the Federal Reserve’s 2% target. However, these concerns were often outweighed by confidence in the strength of the U.S. economy.

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Donald Trump’s return to the White House last month initially boosted optimism in the concept of "U.S. exceptionalism"—the belief that the U.S. possesses unique economic strengths. This optimism was expected to support the broader stock market and the U.S. dollar. However, recent developments suggest that stagflation concerns are gaining traction.

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U.S. stocks are underperforming their European counterparts in 2025, while the ICE U.S. Dollar Index has fallen by 1.7% year-to-date. The Dow Jones Industrial Average and S&P 500 experienced their sharpest declines of the year during Friday’s session, despite the S&P 500 reaching a record high of 6,144.15 just days earlier.

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Strategists at Morgan Stanley noted that investors are increasingly skeptical about the sustainability of the "U.S. exceptionalism" narrative. This skepticism has been a recurring theme in their discussions with clients. Similarly, Tom Essaye, founder of the Sevens Report, highlighted the growing risk of stagflation as a potential new obstacle for the stock market.

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The upcoming release of the January personal consumption expenditures (PCE) price index—a key inflation gauge for the Federal Reserve—will be closely watched. Economists expect both the headline and core PCE figures to rise by 0.3% on a monthly basis, matching or slightly exceeding the previous month’s levels. On an annual basis, these figures are projected to ease to 2.4% and 2.6%, respectively.

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Market participants are particularly concerned because stagflation presents a complex challenge for central banks. According to Will Compernolle, a strategist at FHN Financial, there is no straightforward policy solution for addressing both rising inflation and slowing growth simultaneously.

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Despite the Federal Reserve’s aggressive interest rate hikes between 2022 and 2023, inflation has remained stubbornly above 2% since breaking out in late 2021. Inflation tends to spread quickly throughout the economy once businesses and consumers adjust to a higher price environment.

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Recent data indicates that inflation expectations are rising. Americans now anticipate inflation above 3% in the coming years, while business input prices continue to climb. Furthermore, the five-year breakeven rate—a measure of market expectations for future inflation—has reached 2.61%, its highest level in two years.

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This increase in the breakeven rate raises the likelihood of a stagflation scenario, according to Kelvin Wong, a senior market analyst at OANDA. Wong believes the Federal Reserve may adopt a less dovish stance, tightening liquidity conditions and potentially creating a negative feedback loop for the U.S. stock market.

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On Monday, major U.S. stock indexes closed mostly lower, with the Dow barely recovering after a sharp 748-point drop on Friday. Meanwhile, yields on two- and ten-year Treasury notes fell to their lowest levels of the year, reflecting increased demand for safer assets.

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Other recent economic data has also fueled stagflation concerns. Reports showing weak service-sector activity, falling consumer sentiment, and a sharp drop in existing-home sales point to slowing economic growth. January’s retail sales report, released on February 14, was particularly disappointing, reinforcing fears of an economic slowdown.

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According to Compernolle, there is little upcoming data that could change the market’s current pessimistic outlook. If inflation remains elevated and the federal funds rate stays high while economic growth weakens, stagflation worries are likely to persist.

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The January PCE data, due Friday, is seen as a crucial indicator for investors. Compernolle warned that a higher-than-expected reading could trigger a selloff in bonds. A strong jobs report or a softer consumer price index (CPI) for February might ease concerns, but these figures will not be available until March 7 and March 12, respectively.

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As investors grapple with stagflation risks, the Federal Reserve faces a difficult balancing act. With inflation remaining sticky and signs of economic weakness growing, the central bank’s path forward is becoming increasingly uncertain.

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