Analysis: Which sectors perform best during stagflation?
By Rob Griffin
13:13, 12 October 2021
Soaring energy prices have sparked fears of a return to stagflation – the economic environment that sees rising inflation combined with rapidly declining output.
It’s a scenario that reminds people of the 1970s in the UK, according to a report seen by Capital.com from Liberum Capital strategist Joachim Klement.
“This time, growing concerns about rising inflation as supply chain shortages and gas prices soar in the UK are driving stagflation fears,” he said.
Risk-off environment
Concerns that high energy prices could harm the recovery have been raised recently, according to Liberum’s study, entitled: ‘What to do in a stagflation period’. This has led to a risk-off environment.
UK inflation coming in higher than expected – hitting a nine-and-a-half-year high of 3.2% – while rising job vacancies sparking worries over labour shortages have added to the feelings of unease.
Even though unemployment data emphasised the strength of the recovery, pointed out Klement, this has also contributed to growing fears in the markets.
“First, possible labour shortages might add to high inflation pressures and second, lower unemployment would justify a possible tapering of the BOE’s asset purchase programme,” he said.
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Gas prices hitting record highs
These factors have coincided with gas prices hitting record highs.
“In the UK, natural gas futures maturing in November have risen from 69p per therm to 285p (+636%), temporarily surpassing 400p on 6 October,” said Klement.
Despite recent UK growth data showing economic improvements, Klement noted investors have focused on soaring energy prices in Europe and uncertainty regarding central bank tapering.
“While we do not think that we are heading for an extended period of stagflation, markets will continue to price in the probability of high inflation paired with low growth,” he said.
Lessons from the 1970s
According to Liberum’s analysis, three types of businesses have performed well during various stagflation periods over the last 30 years, these are companies that:
- Produce the commodities that are driving inflation.
- Have pricing power and producing essential goods and services.
- Are vertically integrated and less dependent on third party suppliers.
Sectors that suffer in stagflation
Liberum found that cyclical areas of the market suffered the most under high inflation and low growth conditions.
“Sectors such as building materials, construction, paper products and financial services experienced negative returns,” said Klement.
Oil equipment and production were also found to be in negative territory as the “demand effect coming from low growth” seems to have outweighed rising inflation.
“However, in the current environment, where inflation is mostly driven by higher energy prices, we would expect oil equipment and oil and gas producers to do rather well, due to the differing nature of inflation,” he added.
Best performers during stagflation
At the other end of the scale, sectors engaged in the manufacturing of food, beverages and household products, as well as utilities and pharmaceuticals, performed best.
“This confirms the lessons from the 1970s and early 1980s when these companies were among the best performers as well,” pointed out Klement.
Perhaps surprisingly, real estate has outperformed during these periods, as the positive impact of inflation-linkage in rental income outweighs the negative effect of lower demand growth.
Stocks that have performed best
Liberum then turned these observations into stock examples by looking at companies in the FTSE All-Share with history in at least 12 periods out of the 24 identified stagflation quarters.
Those with the best median returns during stagflation were found to be Senior, the engineering solutions group, which returned 15.3%.
It was followed by TT Electronics with 14.1%, chemicals company Synthomer on 13.9%, and Euromoney Institutional Investor, the media company, with 12.6%.
Conclusions
Liberum discovered that 20 sectors out of the 35 analysed ended up underperforming their historic media under stagflation conditions.
Meanwhile, banks were found to have virtually the same return, while the remaining sectors actually outperformed in such environments.
The best performances came from real estate, beverages, mobile telecoms, retail, electricity and life insurance. This shows staflationary periods are dominated by defensive areas.
“We conclude that defensive sectors and companies with pricing power tend to perform best, such as food and tobacco, pharma and utilities) as do companies that are vertically integrated,” said Klement. “Cyclical sectors, such as construction and tech hardware, suffer.”
Other observations
Klement also believes the recent correction in UK markets has led to an oversold situation, which is providing some potentially attractive opportunities.
“Some stocks, particularly in the retail and building materials sectors are extremely oversold now and worth a look,” he said.
In addition, he points out that fund flows indicate that investors were coming back into equities in September, thus “reinvesting their money after the summer”, just in time for the correction.
Read more: Stagflation fears mount as UK manufacturing growth slows
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