Bank of America warns stagflation scenario will tank stocks, says keep buying energy shares

Published Thu, May 19 202212:34 PM EDTUpdated Thu, May 19 20221:43 PM EDT

Chances for a stagflation environment of low growth and high prices are increasing and making energy stocks the most attractive investment, according to Bank of America. The bank's strategists said in a note Thursday morning that stagflation, last seen in the U.S. in the late 1970s and early 1980s, is generating a "realistic worst case" scenario where the S & P 500 falls to 3,200, or another 18.4% from Wednesday's close. That outcome would follow the Federal Reserve's ongoing efforts to halt inflation by raising interest rates, which in turn would eat into corporate earnings potential. In that case, energy has a potential 89% upside implied by relative forward price to earnings, as well as 33% implied upside using price-to-book, and a 47% upside gauged by price to operating cash flow. "Energy screens #1 in our tactical framework for the 11th month, followed by Materials," Savita Subramanian, Bank of America's equity and quant strategist, said in a note. "Commodity price inflation helped both sectors, but China risk, a strong [U.S. dollar] and recession are headwinds for Materials, just moved to underweight, given China exposure and a shift from goods to services. We remain overweight Energy, which benefits from low US supply, accelerating services demand and war." Consumer prices rose 8.3% year-over-year in April, while producer prices accelerated by 11% . Commodity-related sectors tend to do well in times of rising inflation as cheaper U.S. currency makes dollar-denominated assets more attractive. From an investing perspective, energy is the only positive sector on the S & P 500 in 2022, rising more than 45% on soaring prices and expectations of persistent inflation for the next several years. The war in Ukraine also has played an important role in keeping oil and gas prices climbing. Subramanian said the current market setup looks a lot like the 1999-2000 plunge, as the dotcom bubble was popping. She characterized that time as the "acceptance of the unthinkable," including negative real interest rates and negative risk premiums, or the return investors expect on risk assets vs. government bonds. Even with surging rates, Treasurys have easily outperformed equities this year. "Real rates just flipped back to positive, putting us in rational territory. But don't start the party yet: after the ERP flipped to positive in 2001, it took another 14 months for the S & P 500 to trough," Subramanian wrote. She said investors should be on the watch as "recession risks are taking over" and real rates are not rising while a growth scare intensifies.