What exactly is stagflation, have we entered it and can you invest your way out of it?

Published On: April 25, 2022Categories: Alternative Investments7 min read

We’ve heard a lot about inflation over the past year and with good reason. In the UK it reached 7% over the year to March and is expected to average 7.4% this year. The prices we are paying for goods and services have leapt noticeably over a relatively short period of time in a way that hasn’t been seen in a generation. And the expectation is that we can expect more price rises to come with the war in Ukraine contributing to higher energy, commodity and food prices.

At the same time, global growth is slowing. In its half-yearly update issued last week, the IMF said prospects had worsened “significantly” in the past three months and revised its growth estimate for 2022 down from 4.4% to 3.6%.

The fund said every single G7 member and the bigger developing countries would have less economic growth this year than previously expected. And that there was a strong risk of an even worse outcome. Pierre-Olivier Gourinchas, the IMF’s director of research and economic counsellor stated:

“In the matter of a few weeks, the world has yet again experienced a major, transformative shock. Just as a durable recovery from the pandemic-induced global economic collapse appeared in sight, the war has created the very real prospect that a large part of the recent gains will be erased.”

This year the UK economy is expected to be among the least badly hit with the IMF  forecasting 3.7% growth down from a pre-war estimate of 4.7%. The USA is expected to experience a similar level of growth. However, the situation in the UK is tipped to deteriorate next year when GDP is expected to grow at a rate of just 1.2%.

While that is still growth, it is growth with a weak pulse and would leave the UK economy vulnerable to slipping into recession in the event of any further shocks. Such a shock could quite conceivably come from the need to raise interest rates faster and further than there is recent experience of in a bid to control inflation.

This week The Economist argues that the U.S. Federal Reserve left raising interest rates too late because it was determined to wait until unemployment rates had reached optimal post-pandemic lows. The result, the publication argues, is likely to be that the staggered 2.5% rise in the base rate currently pencilled in for the year will prove insufficient to rein in inflation.

Unless average salary levels rise quickly and sufficiently enough to offset the highest levels of inflation since the late 1980s, which looks very unlikely as spiralling overheads squeeze businesses, further rate rises may be necessary. Even if inflation has now peaked, as some of the more optimistic economists believe it probably has, it is almost certain to remain significantly above the 2% target set by the Fed for a long time to come.

Roughly the same can be said of the UK but our economy doesn’t have the same global influence as the world’s largest, which has historically been shown to give the rest a cold when it sneezes. Having recognised that inflation was spiralling out of control late the Fed looks like it will now have to bring in more severe measures to put the breaks on a U.S. economy hopped-up by the huge $1.9 trillion stimulus package introduced last spring to boost the pandemic recovery.

The historical evidence suggests the Fed will struggle to apply the economic breaks without catalysing some level of recession. It has only thrice managed to slow the economy without instigating a downturn in 60 years and never after a period of rapid inflation comparable to that we’ve just had.

Inflation remaining heightened and limp or negative economic growth would meet most definitions of the term stagflation.

What exactly is stagflation?

There is no technical economic definition for stagflation in the same way there is for recession. However, it is generally accepted to refer to a period during which inflation levels are high and economic growth weak or unemployment rates high.

Unemployment rates in developed economies are currently very low and aren’t expected to rise dangerously any time soon. But inflation levels are high, are likely to remain elevated for at least 2-3 years, and economic growth sluggish to the point of vulnerability.

The term stagflation is believed to have been coined in 1965 by the Conservative politician Iain Macleod. Addressing parliament he told MPs that the UK was facing

“the worst of both worlds. Not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of stagflation situation”.

At the time Mr Macleod was speaking, the UK’s inflation rate was 4.66% and growth had dropped from 5.5% the previous year to 2.2%. This year, British and US growth rates are expected to be better than that but inflation also higher than it was back in 1965. And next year it is more than possible that growth on both sides of the Atlantic drops below 2.2% with inflation at around or higher levels at the time of the “sort of stagflation situation” outlined in parliament almost sixty years ago.

There’s a strong argument we’re already in a period of stagflation and it could potentially continue for another couple of years or longer.

Can you invest your way out of stagflation or at least minimise its impact on your finances?

When the economics of our day-to-day lives change, investors can adjust their portfolios to compensate. As the cost of energy commodities like oil and gas have leapt in the last year, so have the valuations of the companies selling oil and gas. The same can be said of agricultural commodities and food prices and the valuations of the companies selling those products.

That means investors can potentially offset paying more for fuel, energy and groceries by earning more from investments in these sectors. But does that still work when, as Mr Macleod said back in 1965, we “face the worst of both worlds” and stagflation?

Hoping to make significant gains without taking on high levels of risk that could go badly wrong during a period of stagflation is unrealistic. But there are ways to adjust an investment portfolio for stagflation that should limit the downside and could even maintain a level of growth.

If you are ten years or longer from needing to draw down investments you could choose to do absolutely nothing. If you are confident your portfolio is well balanced for the long term there is nothing wrong with sitting tight, taking a hit now and remaining confident the years ahead will see your holdings recover and prosper.

But if your timeline is shorter or you would like to make some damage limitation adjustments, what can you do?

Equities investment for stagflation

It probably comes as little surprise that stagflation is not generally positive for equities. A Schroders study shows Wall Street equities have lost an average of 7.1% during periods considered to represent stagflation since 1988. UK equities were down an average of 2.9% over the same periods.

However, growth stocks and companies selling discretionary goods and services are worst affected, explaining why U.S. stocks have been historically poorer performers than London-listed companies during periods of stagflation. Wall Street has far more growth stocks than London, which is heavily weighted towards energy, finance and mining stocks. And exactly those are the sectors that typically do well during periods of higher inflation.

The same stocks that would be invested in to combat inflation, like energy companies, agriculture companies, miners and banks, make sense for stagflation.

Bonds for stagflation

Fixed income investments like bonds usually do well when stock markets are struggling and interest rates rising. But if inflation rates are also heightened as they are now, investing in bonds becomes problematic as even higher interest rates can still run at a significant loss to inflation.

But bonds to offer a level of security and diversification to a portfolio so shouldn’t necessarily be rejected altogether. An option is for investors to be a little more aggressive and go for short term higher interest bonds such as emerging markets debt.

Schroders says U.S. ten-year government bonds have returned an annual average of 6.3% during periods of stagflation while UK equivalents have returned just 0.4%. So there could be an argument for buying U.S. debt rather than investing in British gilts.

Commodities and property

Periods of stagflation have historically been good for “tangible” assets like commodities and property, which are seen as a safe and effective way to preserve capital.  Schroders says commodities have returned 18.1%during times of stagflation since 1988, gold 14.1% and REITs (real estate investment trusts, which mainly invest in commercial property) 9.5%.

So if you do decide you want to make stagflation-proofing adjustments to your investment portfolio, history says it may be wise to dump growth stocks in favour of those of companies selling essentials like energy and food. Go for shorter-term, higher risk but higher reward emerging market bonds or mid-term U.S. treasuries for fixed income security. And consider commodities, gold and property too.

Or if you have time on your hands you could always do nothing and wait for recovery while potentially buying up bargain growth stocks you consider to have been oversold.

About the Author: Jonathan Adams

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