Understanding Stagflation and How to Invest Through It | Barita Insights | August 30, 2022

Introduction
The current economic backdrop is characterized by slowing growth, stubbornly high inflation and tremendous uncertainty, driven by geopolitical tensions in Europe, challenges in the domestic Chinese economy and a shift towards tighter monetary policy by many Central Banks. At the onset of the Covid-19 pandemic, inflation was subdued, declining roughly one (1) percentage point globally amidst a collapse in demand and plunging oil prices driven by a decline in business activity and limitations on travel and social gatherings. Following the lows in mid-2020, global inflation rose sharply on supply chain bottlenecks in energy and key manufacturing inputs. These bottlenecks emerged amidst a sharp rebound in demand, supported by Governments’ fiscal initiatives and accommodative positioning by major developed market Central banks. Compounding the inflationary pressure was the invasion of Ukraine by Russia, which contributed to supply shocks in key energy and agricultural commodities. However, global growth has been trending in the opposite direction this year and with increasing concerns of a recession, particularly in the USA, the risk of stagflation has become a worthy consideration.

Understanding Stagflation
When an economy faces slow growth and a high unemployment rate along with inflation, this is generally referred to as stagflation. This is a particularly challenging environment for economic policymakers to face, as initiatives that address one factor, may make things worse for another. Stagflation was first coined by British politician Iain Macleod during a speech at the House of Commons in 1965. This was a time of economic strain in the United Kingdom, with the term simply characterizing the combined effect of economic stagnation and inflation.

The root cause of stagflation is still a point of debate among economists, however, in general, a supply shock tends to precede stagflation. This is often an unforeseen or “black swan” event, such as a dislocation in the supply of oil or a shortage of key manufacturing components not unlike the dislocation outlined above. Before the 1970s, it was commonly believed amongst economists that the relationship between inflation and unemployment was inverse and stable. This was based on data going back to the 1860s illustrating this phenomenon. It was expected that an increase in the demand for goods during economic expansion would drive up prices and this would encourage businesses to expand and hire more employees. On the other hand, in a recession, unemployment would increase amidst lower demand, putting downward pressure on prices and by extension lowering inflation.

The environment that emerged in the 1970s was at odds with these prior assumptions. The Arab oil embargo in 1973 resulted in a tripling of crude oil prices during a period of weakness for the U.S. economy. This period was characterized by growing federal budget deficits, exacerbated by spending on the Vietnam war and Great Society social spending programs geared at reducing poverty, and the collapse of the Bretton Woods agreement pegging advanced economy currencies to the U.S. dollar. Additionally, U.S. monetary policy at the time was relatively dovish as the Federal Reserve prioritized propping up growth at the expense of taming inflation. Conversely, the current approach by the Federal Reserve is much more hawkish, with an apparent resolve to address inflation at the expense of higher unemployment and reduced growth. Notwithstanding, for the time being, inflation remains elevated and is expected to come in above target over at least the next year. Additionally, GDP growth in the U.S. has been negative over the last two quarters, fanning fears of recession and stagflation risk. As such, it is worth considering the ideal investment approach in a stagflationary environment.

Investment Implications of Stagflation
According to Bridgewater Associates, since 1960, globally, during periods of stagflation real estate and equities have produced the worst returns on average, with annualized excess returns (alpha) of -13.8% and -10.2% respectively. Fixed income securities across the spectrum also had negative excess returns, with inflation-linked bonds being the only outlier with a positive return of 4.5%. Commodities were the top performer generally, broadly achieving an average annualized excess return of 10.5%, with gold, producing a return of 17.6%. However, it is essential to note that if the stagflation was accompanied by a tighter policy stance that drives risk premiums and discount rates up, while the ranking of returns across asset classes didn’t change, the impact was far more severe, with negative excess returns across the board. Therefore, in such a scenario, while it may not be intuitive, it may be ideal to prioritize liquidity, perhaps with an overweight exposure to shorter-dated government securities.

Conclusion
There is no definitive remedy for stagflation, however, the going consensus among economists is that an increase in productivity sufficient to generate higher growth without additional inflation is ideal. This is expected to leave room for tighter monetary policy which can then be used to tackle the inflation component of stagflation. Such an approach is likely difficult in practice which is why the preference is generally to avoid stagflation at all costs. Given the challenges such an environment presents to investors, it is best to retain excess liquid reserves, with remaining investments skewed towards commodity-backed securities, inflation-linked securities and higher quality short-dated government securities.