What Happens To The Markets During Stagflation?

The global economy is going through a period of high inflation. India’s inflation has been above the Reserve Bank of India’s targeted range for five months. The US CPI is at a four-decade high. The world’s largest economy contracted 1.4% in Q1 2022. GDP contraction and high inflation is causing speculation about whether the US economy is entering a period of stagflation.

But What Exactly Is Stagflation?

Stagflation is a simultaneous period of high inflation and slow growth. Rising unemployment means a possible loss of income. Those who manage to retain jobs see their purchasing power curtailed as prices of essentials increase.

The first description of stagflation was in the 1960s as a “stagnating situation.” The term’s first usage happened in the US in the 1970s when the economy saw negative GDP for five straight quarters. US inflation doubled in 1973 and hit double-digits in 1974. The unemployment rate in 1975 was 9%.

The current unemployment rate in the US is 3.6% which is at pre-pandemic levels, prompting economists to not term the current situation in the US as “stagflation.”

What Causes Stagflation?

Government overprinting currency is one of the biggest causes of stagflation. The US Federal Reserve printed $3T between March-June 2020 and another $325B in 2021. The practice, known as Quantitative Easing, was done to keep long-term interest rates low and boost economic growth.

Excess liquidity in the system leads to inflation, which the US economy is witnessing. The US Federal Reserve has embarked on a rate hiking cycle and winding down its balance sheet.

A sudden supply shock or a sudden increase or decrease in supply is another factor that can trigger stagflation. Crude oil prices spiked earlier this year after Russia invaded Ukraine. Brent prices remain above the $100 mark. The world is also grappling with supply chain issues. Shortage of critical components across industries and higher oil prices have sent input costs soaring. High input costs impact the profitability of companies.

Previous Instances Of Stagflation

There have been two prior instances of stagflation in the US economy. One was between 1974-1975, and the other was between 1978-1982. Both periods overlapped a recession in the US.

Zimbabwe saw stagflation in 2018 and 2019 when a series of economic shocks caused the government to print excess money as economic output declined.

Asset Classes During Stagflation

• Cash: Investor cash stockpiles in the US are at the highest since 9/11. The Bank of America survey of Fund Managers found 6.1% of their assets in cash, up from 5.5% last month. Inflows into ETFs tracking treasury bills are the highest since 2020. The US Dollar index is at a 20-year high as investors flee equities in search of haven assets. Ever heard of “Cash is King?”
• Commodities: Many base metals are trading at multi-month lows due to a stronger greenback. This contrasts with the general perception of commodities as a hedge against inflation. For example, in the latest episode of Winvesta Insights, David Lennox of Fat Prophets projects Gold prices to reach $2,500/Oz, contingent on the US dollar’s weakening.
• Equities: This is one asset class that sees a significant impact during stagflation. Companies grapple with falling revenue, rising costs, and lower profit margins. Experts suggest investors be cautious of “growth stocks” in such scenarios. Growth stocks have seen a sharp sell-off this year, most of which have lost half their value. Analysts ask investors to adopt a “barbell strategy” and own stocks with cheaper valuations, high free cash flow, and dividend yields.
• Bonds: This asset class is a contrast. While they benefit during stagflation due to falling real interest rates, rising inflation is a dampener. Higher inflation will put upward pressure on yields and downward pressure on prices. The US 10-year bond yield has a current coupon of 2.57%. Pairing that against an 8% inflation rate, investors will only have losses to face.
• REITs: Real Estate Investment Trusts or REITs are still gaining prominence among investors. As of March 2022, REIT returns were between global equities and global bonds. REITs can act as a partial inflation hedge as an increase in property prices, and rental contracts will result in a pass-through to investors. But bond yields and mortgage rates moving significantly higher will impact the value of properties.

Conclusion

A World Bank report in June talks about the rising risk of stagflation with potentially harmful consequences for middle-and-low-income economies. Amidst such volatility, all investors can do is follow the age-old adage – “Buy Right, Sit Tight.”

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