Hermione TaylorWhat is stagflation and why is it a problem?
The term stagflation, a portmanteau of ‘stagnation’ and ‘inflation’ was coined in 1965, by UK MP Iain Macleod, as the economy was facing an unexpected period of high inflation and low economic growth. Macleod referred to it as “the worst of both worlds”, and, economically speaking, he was right.
The first problem with stagflation is that the combination of rising prices and low growth leave workers feeling doubly hit. Their money loses value as future prospects stall.
This idea has also been incorporated into a measure known as the ‘Misery Index’. This is calculated by adding the unemployment rate, the lending rate and the inflation rate, minus the percentage change in GDP per capita. Stagflation, with its high prices and low growth, can therefore see a country soaring up to the top of the misery rankings.
One of the most concerning effects of stagflation is the challenge that it poses to policymakers. It was traditionally held in economics that higher inflation is usually associated with low unemployment and a booming economy. The solution to soaring prices was therefore for the government to hit the brakes, either through increasing taxes or raising interest rates.
In a period of stagflation the economy is already stagnating, leaving governments reluctant to implement these policies and slow it further. This problem is also acute for developing economies.
According to Gabriel Sterne, Head of EM Macro Research at Oxford Economics, under a stagflation shock “the amount of fiscal effort required to stabilise debt in Brazil and South Africa could be sufficient to cause considerable political tensions”.
A period of stagflation can also prove difficult for investors. Strategies that work in times of high inflation are complicated by the challenge of lower growth, and even traditional ‘safe havens’ can struggle.
History of stagflation
Though the term was coined in the UK, the US found itself experiencing its own periods of stagflation during the second half of the last century.
In 1964, the economy was experiencing low inflation of 1%, and relatively high unemployment at 5%. Ten years later, inflation was high at 12%, but this didn’t correspond to low unemployment – it sat at above 7%. By 1980, inflation was near 14.5%, but unemployment was even higher. The old trade-off of high inflation for low unemployment seemed to have truly broken down.
The UK also faced its own periods of stagflation, most famously in the 1970s, which saw low growth and simultaneous high inflation.
The Bank of England has since identified some key drivers: unanchored inflation expectations (there was no 2% inflation target at the time), energy supply shocks, and high bargaining power of workers leading to wage increases.
Some of these sound familiar today, so could we be facing another period of stagflation?
How can stagflation hit traditional investments?
The big problem is the ‘inflation’ part of stagflation – when prices are rising, money becomes worth less in real terms. This is firstly a problem for income stocks. If dividends don’t increase at the same pace as inflation, income investors are left worse off, and sell-offs are possible.
The ‘stagnation’ part of stagflation also poses its own difficulties for stocks. When economies enter a period of slow growth or recession sales slow down too, reducing profits and the likelihood of dividends being issued at all.
Growth stocks can also suffer during stagflation. The value of growth stocks tends to hinge on their future projected earnings: what investors think they are capable of in the longer term. High inflation erodes the value of these future earnings, reducing demand for growth shares and causing the share price to dip.
When high inflation is combined with stagnant growth as we see in stagflation, earnings projections could be reduced even further. This could put even more downward pressure on the share price of growth companies.
The overall impact of stagflation in bond prices is therefore uncertain, depending on whether investor fears about inflation or stagnation dominate.
Where to invest during stagflation
In theory there are no clear safe haven investments for stagflation, but empirical evidence shows a more complex picture. Sean Markowicz, Strategist at Schroders investigated the impact of high inflation on the stock market.
Shroders research suggests that equities outperformed inflation 90% of the time, but only when inflation was below 3% on average. When inflation rose above 3% equities fared worse. In fact, “no better than a coin toss”.
Schroders also found evidence that not all sectors fared the same and the energy sector was able to beat inflation 71% of the time. These companies benefit from inflationary spikes because rising energy prices are often a key driver of inflation.
A recently published research paper, The Best Strategies for Inflationary Times, also found that the stocks of energy-linked companies that focus on exploration and production of oil, gas and renewable energy have outperformed other stocks during periods of above 5% inflation rate in the US.
According to Laith Khalaf, head of investment analysis at AJ Bell, the reason these companies may benefit from inflationary spikes is that rising commodity prices, including cost of energy, often drive inflation.
“If commodity prices are rising, then you would expect the share prices of the companies that are digging the stuff out of the ground and selling it also do well, or at least do better than other areas of the equity market,” Khalaf told capital.com.
But if the economy is simultaneously experiencing stagnation, energy stocks are potentially more vulnerable. As lower economic growth can also result in lower economic output this could reduce demand for energy as less is produced. If this is the case, energy firms can suffer declining profits and tumbling share prices.
Safe havens
Schroders’ findings also suggest that firms in the precious metals and mining sector had a mixed performance, with less than a 50% chance of beating inflation. So, what does a period of stagflation mean for the traditional safe haven of gold?
A 2017 research paper by Lucey and Sharma looked at the relationship between gold prices and inflation in the UK, US and Japan over a forty year period. Their research found that “global financial turmoils do not always come hand-in-hand with gold’s inflation hedging capacity”, and couldn’t conclude empirically that gold prices and inflation had a long run relationship.
For the UK, Lucey and Sharma found that “we can say that gold did offer protection against a rise in both the level of inflation and money supply, though it might fail to do so in the near future”.
Are we seeing stagflation or just reflation?
It is also worth pausing to question whether economies really are facing catastrophic stagflation, or just an unusual reflation after the lockdowns of last year.
Some analysts are more optimistic. Neil Shearing, Group Chief Economist at Capital Economics, argues that the economic picture facing developed economies today looks less like the stagflation of the 1970s and more like the readjustment that followed the Second World War.
His research compares demobbed workers returning to the workforce with workers returning from furlough en-masse, and notes the similarities of high post-war excess savings and soaring commodity prices.
Overall, Shearing leads with a note of optimism, concluding that “while the challenges facing the economy were huge, the sky did not fall in. In fact, following a recession in 1946, UK GDP growth averaged a solid (though unspectacular) 2.25% a year between 1947 and 1960. This serves as a useful check on some of the more extreme economic pessimism that has prevailed in recent weeks”.
Policymakers across the world are keeping a close eye on inflation figures as economies start to recover from the long lockdowns of last year. While it remains to be seen whether we are about to enter a sustained period of global stagflation, perhaps investors can prepare for the worst while hoping for the best when devising their stagflation investment strategy.
