Stagflation is when three significant rates – high inflation, high unemployment and stagnant economic growth – are present at one time. Hence the portmanteau of stagnation + inflation.
It’s unusual for these three states to occur simultaneously and the impact on investment performance can be profound.
If in the U.K. we are heading into a period of stagflation like the one experienced during the 1970s oil crisis, an understanding of what causes stagflation can help to guide your investment strategy and help you choose assets that can help to protect you as much as possible against negative impacts.
What Causes Stagflation?
TTypically, inflation and economic growth have a positive correlation.
In periods of stagflation, this correlation is negative – which is caused by several factors.
Supply Shocks
One of the primary culprits is a very sudden disruption in the supply of a crucial commodity, often oil.
Sudden spikes in oil prices push costs up for businesses and consumers, but don’t increase economic growth. For instance, we can see this in action during the period of stagflation that the U.K. experienced in the 1970s as the result of the oil crisis.
The world spent the early 2020s managing an energy crisis, impacted by supply issues resulting from Covid-19 and the war in Ukraine.
In April, members of the Opec+ cartel surprised everyone by announcing that they were cutting production from May, reducing the supply of crude oil by more than one million barrels a day. This caused a spike in oil prices, and has had a knock effect on the wider economy.
The stagflation of the 1970s provides a classic historical example of how supply shocks can devastate an economy. The oil embargo imposed by petroleum exporting countries created an energy crisis with skyrocketing energy prices that had a direct impact on both consumers and businesses. This led to widespread job losses and a recession, while simultaneously driving rising prices across goods and services. Many economists consider this period as offering the definitive definition of stagflation – the worst of both worlds, with inflation on the one side and economic stagnation on the other.
Government’s Poor Economic Decision-Making
Government fiscal policy can contribute to stagflation in a few ways, normally either through excessive government spending, or keeping interest rates too low.
Looking at the situation in the U.K., many would argue that although independent, the Bank of England fell under pressure to resist increasing rates to combat soaring inflation, and that its slow response trapped us in stagflation.
Central banks like the Federal Reserve and other monetary authorities play a crucial role in either preventing or enabling stagflation through their monetary policies. When a central bank increases the money supply too rapidly while the economy experiences slow economic growth, it can create the perfect conditions for stagflation. This contradicts traditional Keynesian economics, which had suggested that inflation and unemployment would typically move in opposite directions rather than rising simultaneously.
The National Bureau of Economic Research has documented how the combination of high inflation and slow growth in gross domestic product creates particularly challenging economic conditions that conventional policy tools struggle to address. With signs that the UK economy is heading for stagflation in current times, many are looking back to lessons from the 1970s and 1980s when stagflationary pressures created prolonged economic hardship.
Stagflation vs Inflation vs Deflation: What are the differences?
The difference between inflation, deflation, and stagflation is very simple to understand. Inflation and deflation both refer only to changes in the retail price index (RPI).
If prices are going up, the value of money is falling: each pound buys less than before – this is inflation. On the contrary, if prices are falling, each pound has more purchasing power – this is known for deflation.
Stagflation is a unique economic situation where inflation is only one of three contributing factors. There are also high levels of unemployment and low or stagnant economic growth to contend with.
It’s important to understand that stagflation is not just inflation – it’s the combination of higher inflation, slow growth in gross domestic product, and rising unemployment. This creates a particularly toxic economic environment where rising prices reduce consumer purchasing power while job insecurity increases. People have less money to spend precisely when higher prices are demanding more of their income, creating a downward economic spiral.
During periods of high inflation alone, economic growth can sometimes compensate by creating more jobs and increasing wages. But stagflation combines price increases with economic stagnation, making it far more destructive to both individual finances and national economies. Fuel inflation often acts as an early warning sign that stagflation could be developing, as energy costs form a fundamental input for almost all economic activity.
Which Assets Perform Best in Stagflation?
Certain types of stocks and bonds are believed to perform better during stagflation, and can help to protect you against its worst effects.
Here are a few examples of asset classes with the potential to perform well in stagflation, but note that you must always carry out careful research and planning before taking any action.
Defensive stocks: Companies making essentials like electricity, pharmaceuticals, and basic food and hygiene products tend to fare better than others during stagflation. These are the products that are hard for people to cut back on, even during tough economic times.
Commodity-related stocks: Companies involved in producing or supplying commodities that are likely to stay in high demand despite inflation can perform well. This includes the energy sector and precious metals, like gold and silver.
Infrastucture stocks: If the government decides to invest in infrastructure projects as a way to boost jobs and stimulate growth, then companies involved in construction can benefit.
Treasury Inflation-Protected Securities (TIPS): Specifically designed to protect against inflation, their principal value adjusts with it. The idea is that investors won’t lose purchasing power.
Global bonds: Diversifying your bond portfolio with bonds from different countries is a strategy whose goal is to minimise the impact of stagflation in one particular economic area.
Remember, there are no guarantees in the financial markets.
Economic conditions can be complex and unpredictable, and the performance of specific stocks and bonds will depend on more than just inflation and GDP.
When looking to protect yourself from stagflation, it’s essential to understand how different economic theories explain what makes stagflation occur. Some economists argue that excessive tariffs and regulations can reduce supply in the economy while increasing prices for consumers, creating stagflationary pressure. Others point to the consequences of stagflation as potentially long-lasting, especially if a central bank lacks the tools or will to address the risk of stagflation before it becomes entrenched.
Historical analysis shows that when stagflation occurred during the 1970s, commodities outperformed most other asset classes. Gold in particular rose to prominence during the 1970s as a hedge against both inflation and economic uncertainty. While inflation did come down eventually as monetary policies tightened in the late 1970s and 1980s, the process of overcoming stagflation involved a painful recession and significant economic restructuring.
It is advised to do your research and talk to a financial professional before making any investment decision.
Trading Through Stagflation
Trading during stagflation is complex, as it’s not a common economic scenario. You won’t have years of data to base decisions on, and markets can often be unpredictable.
Here are four strategies to consider:
Diversification: When the economy is experiencing this miserable mix of high inflation and low growth, it’s more important than ever to spread your activity across different asset classes to mitigate risks. This theory can apply to currency trading too – spreading your currency exposure across assets denominated in more stable currencies can often be a sensible trading strategy.
Hedging: You may choose to use options and futures during stagflation to hedge against potential losses. You still have the opportunity to profit from price movements, but you get the extra built-in protection too.
Short positions: While no one likes the idea of profiting from someone else’s decline, plenty of industries will struggle during stagflation, and many investors will short those stocks.
Long-term investments: Getting through a period of stagflation can simply be about weathering the storm. Solid long-term investments such as dividend-paying stocks, can be a way to get through short-term economic turmoil.
Potential stagflation scenarios require traders to carefully consider how higher prices combined with unemployment with high inflation will impact various sectors differently. As demand for goods and services falls due to consumers having less money available, companies that provide essential services tend to maintain stability. The term stagflation first gained widespread usage during the bout of stagflation that followed the oil crisis, but stagflationary conditions can occur whenever supply-side factors severely constrain economic output while inflation rates remain elevated.
Understanding the factors behind stagflation is crucial for traders. When inflation is rising but growth in the economy remains stagnant, traditional investments that perform well during economic expansion may struggle. The stagflation means navigating an environment where most economic indicators suggest poor performance ahead. Historically, when inflation has come down significantly after stagflationary periods, it has often been because rises in inflation were addressed through aggressive interest rate increases that temporarily worsened unemployment but eventually restored economic balance.
