Stagflation is a word no investor wants to hear – it combines stagnancy in economic growth rates and inflation – a double trouble combination that doesn’t signal good news.
Table of contents
- The Big Stagflation Issue
- How Current Events Are Impacting Economies
- Advice For Investors In A Stagflation Scenario
- The Value Of Defensive Stocks
- Picking Investment Stocks By Equity Region
- What Does Stagflation Mean for Your Investments FAQ
- Related Information
Slow pandemic recovery, political turmoil, booming living costs and the Russian invasion of Ukraine have gathered together as a series of events, straight off the back of a global pandemic, so it’s little wonder investors are feeling cagey.
In this environment, global equities are exposed since companies are squeezing profit margins as narrowly as they can, trying to juggle revenue drops and soaring costs.
However, not every sector will suffer, and some insulated stock picks have robust defensive properties that may mean they are immune to inflation – or even perhaps show a positive correlation.
The Big Stagflation Issue
Inflation alone can be complex, but it’s not normally a game-changer for seasoned traders and central banks, who are well versed in handling inflation, or the opposite; recession and falling growth.
It gets trickier when you get those two incompatible circumstances at the same time.
Rising prices coupled with economic slowdowns are also a hurdle for investors because it’s not easy to build a portfolio that’s equipped to cope with these competing scenarios.
To put it into context, the last time the world battled stagflation was in 1973, after the Yom Kippur war resulted in skyrocketing energy prices, and world economies stopped in their tracks.
We’re not yet in an official stagflation position, but the signs are there.
How Current Events Are Impacting Economies
Issues with inflation and abysmal growth aren’t wholly attributable to the Russian invasion of Ukraine.
The conflict has, though, made things much worse. The impacts on gas and energy exports have repeated history, creating an energy crisis with low demand, higher costs, unemployment, and razor-thin profit margins.
What’s particularly difficult is that this time, the problems aren’t hitting a world that’s spinning as it normally would – it’s immediately after the gruelling two years of the Coronavirus pandemic that still won’t quite lay still.
Current dilemmas within supply chains aren’t strong enough to deal with energy crisis shock waves, so investors find themselves in a delicate position.
So, what are the central banks going to do?
Most analysts expect the banks to tread slowly and carefully, treating inflation as a lesser problem than a full-blown recession.
So what can you do to position yourself in as favourable a way as possible in a world where stalled growth and creeping inflation aren’t going away?
Advice For Investors In A Stagflation Scenario
The first pointer is to steer well clear of fixed-income investments. Bond prices will inevitably fall, and rising costs mean that diminished purchasing power won’t play out well in fixed-interest payments or static capital returns.
If you’re balancing an investment portfolio with shares, think about:
- Buying shares in businesses with stable stores of value and a solid asset base that is likely to appreciate over time.
- Analysing cash flow alongside financial statements. Profit margins aren’t the be-all and end-all if you buy equity shares in a business that will crumble with liquidity.
- The impact of rising input expenditure. Tech firms are a good call where they’re less vulnerable to rising energy costs than, say, a manufacturing firm operating high-energy usage machinery.
- Returns on capital, looking for businesses with higher price spectrum outputs and sufficient intellectual property to protect shareholders from rising prices.
- Balance sheet net worth. Businesses that are highly geared but on fixed-interest rates (based on previous rates) may be attractive – the investments made with debt financing may appreciate, chipping away at the real-world cost of debt.
Now isn’t the time to go for mega-corporations that won’t be too bothered about shaving margins or high costs, and startups aren’t usually supported enough to survive the storm.
Rather, you’re looking for agile stocks in businesses with the liquidity to self-finance or an inflation-proof product with an ongoing demand that isn’t as vulnerable to stodgy market conditions.
The Value Of Defensive Stocks
Defensive stocks are those with dominance in significant markets and with the longevity or market share to retain a competitive advantage – companies that provide essential products or services.
- Utilities – water, gas and electricity.
- Healthcare, medical supplies and pharmaceuticals.
- Consumer staples – food and beverages and household goods.
Regardless of the economy, anything that we all need is a defensive stock, and share prices normally increase when everything else falters.
For example, people require food, medicine and water every day. Still, they won’t necessarily prioritise a new car, smartphone or gaming device when inflation is making everything more expensive.
A defensive sector statistically outperforms the market when indices fall – the contrast is a cyclical sector, which does the opposite.
Investors tend to shore up their portfolios or rebalance assets of greater risk with high-performance defensive stocks – utilities tend to perform 16 per cent higher in adverse markets, and consumer staples 14.2 per cent higher.
In the current climate, anything cyclical is best avoided – worst performers include IT, with a 6.7 per cent market underperformance.
At the time of writing, crude oil prices were at around $100 a barrel (£76), which means energy sector businesses have enormous cash influxes and are more likely to offer share buybacks or attractive dividend payments.
Our final defensive stock tip – keep an eye on gold.
The commodity price is at £1,926.74 an ounce, over and above the Goldman Sachs 2022 target of $2,500 (£1,908) as reported by Capital.com.
Picking Investment Stocks By Equity Region
It’s not an exact science, but investors troubled by stagflation can choose which equities to buy and offload by weighting returns depending on sectors and regions.
The MSCI UK Index measures the performance of UK market stocks within large and mid-cap segments, covering about 85 per cent of the adjusted market cap in the country.
Approximately 50 per cent of the index includes defensive stocks and energy – compared to 36 per cent in Europe, so it’s a well-balanced index if you’re looking to buck the stagflation trend.
Losers in slow growth, high inflation scenarios include Japan and the United States, with indexes crammed with discretionary and IT stocks.
The UK is a fraction of the global equity market cap, so if you’re looking to counterbalance risk, it may not be sufficient.
Europe is a bigger, badder investment market making up 11 per cent of global indexes (compared to the UK’s four per cent), so it offers a little more wiggle room to make a tactical move to make stagflation an advantage – or at least not a severe disadvantage.
What Does Stagflation Mean for Your Investments FAQ
Who Invented stagflation?
British Conservative politician Iain Macleod first used the term stagflation in 1965, when he made a parliamentary speech. Media outlets picked up on it and repeated the phrase during reporting about economic conditions between 1973 and 1982.
What is stagflation?
It is a combination of stagnation and inflation, as an economic phenomenon that occurs when rising inflation, high unemployment and a plateaued demand from consumers all converge on the economy.
Now an accepted term among economists, they study the elements that contribute to stagflation and can even quantify and predict it, helping us provide investment advice to safeguard your finances.
In essence, stagflation means you should avoid making significant purchases until markets settle.
What should I do to protect my investments from stagflation?
You don’t necessarily need to do anything – if you have a long-term investment strategy, keep following your plan, provided you’re still within your means.
Portfolios with higher-risk investments or more aggressive approaches combined with a lack of diversification may require a risk-limiting approach until stagflation eases.
How is stagflation measured?
There isn’t a singular data point that can measure stagflation – it’s more a case of looking at multiple indicators and examining the general direction over time to see whether contributing factors are converging.
Increases in unemployment and inflation are two of those contribution indicators. One doesn’t mean that stagflation is present or likely, so it’s important to assess a spectrum of relevant data points.
What can investors do in a stagflation market?
Many assets won’t perform well in stagflation periods. Still, there are equal opportunities for investors who want to navigate the markets with a resultant uptick in their portfolio value.
One is time in the market – stagflation isn’t permanent, so a solid option is to ride it out, stick with a longer-term strategy, and wait until volatility and risk drop before you decide on entering or exiting a new position.
It may even be possible to get ahead of the game, purchasing equity assets at reduced share prices and retaining some liquidity to secure viable prospects with the potential to be profitable when challenging conditions subside.
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