Investing during stagflation: What assets to choose
What assets do best during stagflation as equities and bonds become increasingly unattractive?
The shifting economy continues to throw fresh challenges at investors after two years of mammoth growth. The most challenging one though could be around the corner: stagflation.
Stagflation, a period of high inflation and slow economic growth, is an oxymoron that is difficult and painful to overcome. It also makes assets increasingly hard to select.
Equities are becoming less attractive after a couple of years of strong growth as companies face high costs and slowing demand, bonds encounter trouble as interest rates rise, and cryptocurrencies face a long period in the cold as risk appetites drop.
Investing during stagflation therefore requires you to be creative managing your portfolios, with commodities, currencies and real estate being possible avenues to beat inflation and stubbornly slow growth.
What does stagflation mean? The worst of both worlds
Stagflation is seen as the worst of both worlds. High levels of inflation, which are at 40-plus year highs of 9.1% in the US, are beginning to weigh on demand.
But falling demand is unlikely to adequately cool rising prices. Energy costs remain artificially high following Russia’s invasion of Ukraine, and demand is rebounding faster than supply chains can cope with as pandemic-era restrictions are lifted across the globe.
It means interventions by the central banks, most recently the US Federal Reserve’s (Fed) biggest single rate rise since 1994, are unlikely to halt price rises in the short run, but are expected to slow demand, stoking inflation risks.
In June 2022 the World Bank warned that the risk of prolonged stagflation had increased, with forecast global growth more than halving between 2021 and 2022.
It means equities, which have experienced a few years of strong growth and high price-to-earnings ratios, and bonds, popular in a deflationary downturn, have become less appealing for investors.
While these assets aren’t totally hands-off, investing during stagflation means outside-the-box thinking to approach these assets in a different way, and work to incorporate safe-haven and counter-cyclical assets.
What assets do best in stagflation?
The playbook for investing during stagflation is completely different to that used in the prolonged bull market era of 2020 and 2021. It eschews higher-risk equities such as growth stocks and crypto in favour of value and assets that do well in a recession.
The added pressure comes in also trying to outpace inflation, which could mean investors require a return of up to 10% per annum. Analysts say commodities and a select type of equity and bond may be the most effective in threading this needle.
Commodities
According to research by the World Gold Council, historically, the winners during periods of stagflation between 1973 and 2021 have been “defensive assets and real assets, in particular gold, while equities have suffered the most followed by a mixed performance from fixed income.”
An efficient stagflation investment strategy could consider commodities such as oil, and precious metals such as the safe-haven gold.
Brent crude remains elevated at around 14-year highs as energy insecurity mounts, while gold has peaked above $2,000 twice since 2020, and is trading 40% above June 2019 levels.
In a research note published in April 2022, NN Investments said oil prices were likely to continue to rise.
“Crude oil prices are volatile due to geopolitical tensions, solid demand and low inventories. Chinese lockdowns will negatively impact demand; Russian and European oil demand will also adjust downward,” they said.
“Meanwhile, the likelihood of a new nuclear deal with Iran and a return of Iranian production increased. This, combined with supply growth from OPEC+ and elsewhere, should move the oil market to a surplus in the next several months, barring drastic sanctions on Russian oil exports to Europe, which we consider unlikely.”
Equities
Equities remain in the midst of a broad sell-off. The S&P 500 (US500) has lost more than 14% of its value year to date, while the tech-focused US Tech 100 (US100) has lost more than 21%. There is a worry of an earnings recession, which could see equities falling further.
“Stagflationary episodes can be particularly brutal to equity investors, who have historically seen the worst average returns during these phases, squeezed by rising costs and falling revenues,” the World Gold Council research team said.
The agency suggested not all equity indices weather stagflation equally. According to their analysis of historical data between 1973 and 2021, US staples outperformed the consumer discretionary sector during stagflationary periods, with an adjusted quarterly return per business cycle of 7.9% compared with a decline of 1.3% for the latter.
Credit and bonds
While the credit market, including government bonds, looks at increased risk of devaluation from rising interest rates, some analysts see it as a better avenue for rewards in this cycle.
In a research note on how to beat stagflation shared with Capital.com, Barclays was more positive on the yields offered by European investment credit (IG) than by equities, as forecast gross domestic product (GDP) growth by the bank for the next year falls to 0.5%.
“Given flow dynamics year-to-date, it is clear equities remain more consensus than credit, as well. In past recessions, equities fell about 30-35% peak to trough vs. 10-15% for IG credit,” they added.
“Given we are down ~20% in equities and ~13% in IG, arguably we are two-thirds or more of the way there already. On a risk-adjusted basis any further fall in equities might be comparable to that seen in IG, but in absolute terms, equities have more downside risk.”<
Research by Goldman Sachs weighed how investors and policymakers were eyeing stagflation risks and responses back in March, with inflation-linked bonds looking most attractive.
“What we are witnessing is a regime change that we haven’t experienced in modern times, which makes it very difficult to be constructive on bonds,” said BlackRock’s vice-chairman Philipp Hildrebrand.
“This environment also suggests increasing allocations to private markets. We also remain relatively constructive on public equities, but geopolitical risks could derail their returns depending on how the situation evolves.”
Strategies for beating stagflation
It’s important to consider what to invest in during stagflation, but it can be just as important to consider how to invest.
Short selling
While looking for success stories can be difficult amid a wider market sell-off, investors may prefer to take the opposite route. They could take a position against companies they think will come off worst in a stagflationary period in an act known as short selling.
Short selling could also be a part of a hedging strategy, where investors take an opposite position in the market to offset losses during a downturn.
According to data compiled by MarketWatch, healthcare and consumer discretionary stocks are topping the list for the most shorted equities. This includes home health and hospice provider Enhabit (EHAB), and cosmetics skincare and fragrance company Revlon (REV), where 64% and 60% of their respective “floats” (the company’s publicly available shares) were being shorted.
Note, however, that short selling is a risky strategy and you should always conduct your own due diligence before any investment decision. Always have a risk-management plan in place and never trade without a stop loss.
Diversification
Ultimately, it is difficult to compare the current phase with past periods of stagflation, like that seen in the 1970s, and a diversified portfolio is the best approach to current conditions, a Barclays study said.
“Not only have economies become much less dependent on oil since the 1970s, but the trilogy of globalisation, the internationalisation of asset markets and innovative monetary policy have warped the financial landscape. In turn, making it far more difficult, if possible, to compare the economy now with the past,” Barclays said.
Note that analysts’ predictions can be wrong. Forecasts shouldn’t be used as substitutes for your own research. Always conduct your own diligence and remember that your decision to trade or invest should depend on your risk tolerance, expertise in the market, portfolio size and goals.
Keep in mind that past performance doesn’t guarantee future returns. And never invest or trade money you can’t afford to lose.
Final thoughts
All investments carry risks at any time. Those risks are heightened during periods of high inflation and low economic growth, particularly when things are finely balanced between stagflation and a recession.
“Stagflation wouldn’t be good for anyone but some assets would likely be better than others. Investors might turn to real assets with links to earnings or inflation, like property or infrastructure,” said Laith Khalaf, head of investments at AJ Bell, in a note exclusively to Capital.com.
Khalaf also noted that periods of stagflation and recession may be easier to weather for those investors focused on the long-term goals, noting: “Alternatively they could simply look to invest in equities and keep an eye firmly on the long term.”