What is Stagflation? | Guide to Stagflationary investing

Famed economist Nouriel Roubini is warning that the global economy could face stagflation. But what is stagflation? And why is it such a worry?

What is stagflation?

Stagflation is when there is high inflation alongside high unemployment and slowing economic growth.

Both inflation and unemployment are considered undesirable economic forces so naturally a situation when they both come at the same time is especially feared. In short, stagflation is a situation when many people are without an income while the cost of living rises.

It’s an unusual circumstance because inflation is typically associated with a strong economy, not one that has high unemployment or is in recession.

When the economy is strong, the high demand for goods and services can outstrip the supply of them. Economics 101 tells us when demand is above supply, prices rise. The same thing happens with wages. In a strong economy, businesses need workers to help meet demand from customers and workers have the bargaining power to ask for higher wages.

Likewise if the economy is in a recession, it is more often accompanied by falling prices or deflation. Or if not deflation, very low inflation. The reasons are the reverse of what we have already discussed. In a recession, demand for goods and services are low, this results in high unemployment.

The causes of stagflation

Like many aspects of economics, there are different views about the causes of stagflation. The two main theories are a supply shock and bad economic policy. 

what is stagflation
During a supply shock, the economy faces a sudden fall in the supply of an important commodity or good or service. The lower supply causes the price to rise. The problem comes from how quickly the price rises because businesses do not have time to adjust. There are higher costs which negatively impacts on production and results in a fall in profits, losses or for businesses to fail, leading to higher unemployment.

Bad economic policy is when either fiscal or monetary policy are inappropriate for the economic circumstances and hurt the economy rather than keep it balanced as intended. For example, high government spending when there is high economic growth can cause the economy to overheat and eventually crash. Likewise, increasing the money supply into a hot economy can cause inflation to occur just as the economic cycle is peaking, leading to high prices and weak growth.

Past example of stagflation

The most prominent example of stagflation in recent history was during the 1970s. The economic setup in the 1970s was not dissimilar to the 2020s.

stagflation 1970s
In the United States, the Federal Reserve had kept monetary policy loose to help drive demand in the economy with inappropriately low interest rates. In addition, President Richard Nixon introduced new economic policies, including a price and wage freeze, import tariffs and he removed the US from the Gold Standard where all dollars were backed by physical gold. Then in 1973 the OPEC oil embargo caused a supply shock and sharp increase in oil prices, which led to economic disruption amplified by the bad economic policy.

Could stagflation happen soon?

The consensus view among economists is that stagflation is unlikely to reoccur today, but economics is famed for its poor predictive ability. As we noted at the start, one prominent economist is flagging the growing risk. 

Nouriel Roubini wrote the following in an Op-Ed in The Guardian newspaper in July 2021:


In April, I warned that today’s extremely loose monetary and fiscal policies, when combined with a number of negative supply shocks, could result in 1970s-style stagflation (high inflation alongside a recession). In fact, the risk today is even bigger than it was then.


Most economists argue that there is tendency to deflation so if there is another recession, prices are more likely to fall than to move higher. Roubini argues that inflationary forces are growing, which creates a problem for central bank policy and a scenario in which they face the choice of another debt crisis or stagflation.


As inflation rises over the next few years, central banks will face a dilemma. If they start phasing out unconventional policies and raising policy rates to fight inflation, they will risk triggering a massive debt crisis and severe recession; but if they maintain a loose monetary policy, they will risk double-digit inflation – and deep stagflation when the next negative supply shocks emerge. – Nouriel Roubini

How to invest if there is stagflation

Although past performance is no guarantee for what to expect in the future, it’s all we’ve got. Looking at which assets performed well during the 1970s stagflationary period is a useful guide to what could come were stagflation to reoccur in the 2020s.

1) Commodities when there is stagflation

If there is inflation, which is devaluing the dollar then one place for investors to look is in hard assets that can act as a store of value. If the inflation has been caused by a supply shock in some commodities, then naturally riding the rising price of those commodities could also offer some protection. This simple price performance chart showing gold, oil and the S&P 500 during the 1970s demonstrate this point well.

 

gold and oil in stagflation

2) Equities or bonds during stagflation?

From the mid-1960s through the 1970s, equity markets were basically flat, going through a a series of rolling bear markets. On a real (inflation-adjusted) basis, you probably would have lost money being fully invested in the stock market during the 1970s.

stocks and bonds in stagflation

 

Treasury yields spiked with the higher inflation, meaning the price of the bonds tanked. You don’t want to be stuck with 10-year Treasuries priced at below par, earning you approx. 1.5% when inflation is raging perhaps in double figures. If you must have some fixed income exposure during stagflation, then the best place could be TIPS (Treasury Inflation-adjusted Bonds).

3) Sectors for stagflation

Some parts of the economy will weather stagflation better than others and some sectors of the stock markets will outperform. Basic materials and energy industries offer another way to invest in the rising price of commodities.

NOTE: The growth vs value question might become a moot point if there is stagflation. Tech stocks and high growth companies have out-performed in the era of low rates and so by that logic would not fare well during high inflation and in a rising rates environment. However if the economy is in trouble with high levels of unemployment, then industries tied to the economic cycle would see earnings forecasts cut and fall out of favour too.

Overall, stagflation is not a good recipe for equities so playing defence with defensive stocks would probably be wise.

How to start investing for stagflation

FlowBank offer the security of a Swiss bank account with over 50,000 investment products including commodity futures, TIPs and inflation-protected bond ETFs.

Register for a FlowBank account.

bg_newsletter
LiveWire

13 hours ago

Eurozone business growth IHS Markit Composite PMI is at 6-month low

16 hours ago

Consumers will see their wallets shrink as they are the ones incurring rising costs.

18 hours ago

Fintech VC deals YTD have crowded out the rest