Investing At A Time Of Stagflation
Filed in: Momentum |Investment |Pensions |Savings |Economy
12 September 2022
by Andrew Hardy CFA - Momentum Investment Director
Investing at a time of stagflation
Real returns have been easy to come by for the past decade, with most asset classes delivering well ahead of inflation.
The current environment is entirely different though, and has prompted fears of a sustained period of stagflation.
There are few comparable periods in the recent history of financial markets to use as a guide, but were this to continue, the optimal asset allocation and strategy mix for portfolios would likely be very different from that of the post global financial crisis period.
There are slightly varying definitions of stagflation, but it generally refers to a period of slowing growth and rising unemployment (stagnation) together with rising inflation.
These conditions are most challenging for economies and markets when growth is low and inflation is high, and when they persist for a long period of time.
Although unemployment has not picked up yet, we are clearly seeing a significant slowdown in growth this year and sharp increases in inflation; the annual growth in consumer prices in the UK hit 10.1 per cent in August, ahead of expectations yet again and at a 40-year high.
Average incomes have not kept pace so real wages have fallen at the fastest rate in decades. While the UK position is worse than in many other countries for various reasons, a similar pattern is playing out across much of the developed world.
There have been very few extended periods of stagflation in recent history, but the 1970s was the clearest and most acute, and the torrid investment returns over that period explains why the scenario inspires so much fear in markets.
The combination of weaker growth (at least in real terms if not also in nominal terms) and rising prices is generally bad for both equity and bond markets.
For equities, sales are falling and costs are rising, therefore profits are being squeezed. For bonds, rising inflation leads to higher yields and lower prices.
Of course, there are some exceptions but broadly speaking these are the effects of stagflation, with nominal returns below inflation, and in many cases negative in absolute terms.
In contrast, real assets, which include property, infrastructure and commodities, have greater inherent resilience. Such physical, tangible assets can often benefit from resilient or increased demand, or higher prices, sometimes through explicit inflation linkage, while costs can also be contained.
In the 1970s, the standout asset class was commodities. Gold, silver and oil, to name just a few, delivered very strong nominal returns and even double-digit (annualised) returns in real terms, while prices of several other hard and soft commodities also outpaced inflation.
Clearly the oil crisis at the time was a key contributory factor, as well as being the primary source of the inflation problem; there are no guarantees that commodities would repeat this performance in another extended period of stagflation.
While investors are worrying about the risk of stagflation now, it should be recognised that we have felt a lot of the effects of this current bout in markets already.
That does not mean there is no more pain to come, but markets are effective discounting mechanisms and have already adjusted significantly to the realities of lower growth and higher inflation in the near term.
At the start of 2022, consensus expectations pointed towards inflation in many major economies falling back towards target during the year, but the supply shock to energy and commodity markets of Russia’s invasion of Ukraine extended the upward pressure on prices, while also damaging the growth outlook.
That explains much of the weakness in equity and bond markets since then, while true to form, real assets have held up much better.
However, while growth is likely to remain weak and inflation high for several months to come (at least) the key question is around how long these conditions will persist.
Uncertainty cuts both ways; will the slowdown in growth be less acute than feared and will inflation fall faster than expected? These are critical factors that are incredibly difficult to judge; consider how central banks have all but abandoned their forward rates guidance and moved to a more data-dependent, meeting-to-meeting approach, because they face such a dynamic and uncertain situation.
Concerns around the prospects of a 1970s-like period of stagflation are no doubt valid, but there is every chance that will be avoided.
Inflation outlook
Here in the UK, the Bank of England has forecast inflation to reach more than 13 per cent this year, but if commodity prices continue to fall – as has been happening in recent months, driven at least in part by growth fears – then CPI will undoubtedly come down, as we have already seen in the latest print in the US.
Slowing consumption, tightening financial conditions and more normalised supply chains globally will also exert downward pressure.
Also, the more important measures to focus on are core inflation, a less volatile series that better reflects more sticky components of inflation, and wage growth. These reached much higher levels in the 1970s, reflecting a more persistent and troublesome sort of inflation, with wage-price spirals and high inflation expectations, which we are not yet seeing today.
However, until inflation starts to decelerate in a sustained way, risks of this sort of vicious inflation cycle becoming entrenched remain significant.
History tells us that once the inflation genie is out of the bottle it can be very difficult to contain it again. Policymakers face the considerable challenge of bringing inflation back down to target without triggering a slump in growth, which is already under pressure from supply shocks. The risk of error is high.
Market pricing suggests consensus expectations for inflation to normalise back towards target over the next few years; 10-year inflation breakevens in the UK stand at 4.1 per cent, and in the US at 2.6 per cent. That optimistic scenario may be proven right, but the upside risks to inflation have been persistently underestimated for the past 18 months already.
Most market participants have not invested through this sort of environment, and it seems likely that they are overly anchored in the recent, secular stagnation era.
Stagflation or not, it is important to consider how to construct a portfolio to be resilient through a period of elevated inflation, weak growth and structurally higher interest rates than those of the post-GFC era. What is the new playbook?
We continue to advocate higher allocations to property and infrastructure, with a focus on those with more explicit inflation protection built into their revenue or cost structures.
Despite recent outperformance, carefully selected assets in these areas offer higher and relatively more stable yields across a range of scenarios, compared with nominal bonds, which despite this year’s sell off still offer negative real yields and warrant lower allocations than in past cycles.
Stock picking
It is hard to have the same confidence in commodities, given their inherent volatility and lack of yield. Gold is very different though and deserves an allocation, given its proven ability to deliver positive real returns over centuries and its reliable diversification and crash protection credentials. Another adjustment to consider for a period of persistently high inflation is to increase allocations towards value stocks and tilt away from growth stocks.
On average value stocks – usually characterised as lower growth businesses and often found in sectors such as energy, utilities, financials – are more asset-heavy and less sensitive to rising interest rates. Indeed many financial stocks will be direct beneficiaries of higher rates, so accordingly have outperformed growth stocks this year.
The post GFC (Global Financial Crisis) environment saw high growth and tech stocks outperform for the best part of a decade, and valuations become incredibly stretched relative to value stocks – but a new and wholly different regime could result in very different patterns of market leadership.
Balance sheet strength and pricing power – the ability to pass on price rises despite tough economic conditions, will be vital, and evidence is already beginning to emerge of a period of creative destruction, as zombie companies that benefited from the era of cheap money will fall by the wayside.
In such an uncertain and unusual environment, it is also likely that volatility would remain elevated, which would play into the hands of active managers and hedge fund strategies.
Low inflation and low rates equated to equity markets being narrowly driven for many years, making passive strategies much harder to beat, but what we have seen this year may become more of the norm, with greater dispersion creating opportunities for the best active strategies to outperform. Multi-strategy hedge funds have been one of the few sources of positive returns this year.
Higher allocations to cash may be tempting and could be beneficial, to take advantage of the buying opportunities that a period of stagflation/weakness in markets eventually creates with a long-term perspective.
However, while nominal returns on cash and equivalents are rising and will continue to do so, they are still expected to remain negative in real terms. But much has already been discounted and we are likely close to peak inflation; the change in direction will be an important shift for markets.
Also, unlike the GFC, this cycle is not driven by the need for financial deleveraging, and balance sheets of households, businesses and banks are generally strong. This will help to minimise the slowdown ahead and gives the scope for economies to bounce back quite quickly.
At the same time, valuation opportunities have opened up for longer-term investors. With careful diversification, and asset allocation designed for the environment ahead rather than that of the past decade, we believe it is important to ride out any short-term volatility and take advantage of setbacks in markets as the cycle evolves.### A note about Tom
A note about Andrew Hardy
Andrew Hardy is a long-standing member of Momentum’s UK investment team, having been with the company since 2005. Prior to his appointment as Director of Investment Management he was co-Head of Research and has managed portfolios for over ten years, leading on the Harmony Portfolios multi-asset range and global developed and emerging market equity funds.
During his time at the company he has played a central role in developing the team’s investment philosophy and process while supporting business strategy and development. He is a CFA Charterholder and has a BSc in Economics from the University of Bath.
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