Why Are We Talking About Stagflation Today?
In 2024, the term “stagflation” has resurfaced in global economic discussions. The reason is the peculiar economic situation many countries are facing—a combination of slowing economic growth and persistently high inflation. This has raised alarms among policymakers, investors, and consumers, who vividly remember the stagflationary periods of the 1970s.
Several factors are driving this conversation --- that started in 2022. First, the COVID-19 pandemic disrupted global supply chains, leading to shortages and higher prices across a range of goods. These disruptions were exacerbated by geopolitical tensions, such as the war in Ukraine, which further increased energy and food prices. Central banks responded to rising inflation by hiking interest rates to curb demand. However, this strategy also dampened economic growth, as businesses and consumers found borrowing costs rising. This led to slower growth, while inflation remained stubbornly high (reaching 40-year highs) —a potential recipe for stagflation.
As global economies wrestle with these issues, the threat of stagflation looms large. Economists are carefully monitoring economic indicators to assess whether we are in the preliminary stages of stagflation or merely experiencing a temporary period of slow growth and high inflation.
Although there are concerns in various economic circles over stagflation the probability currently remains low. The US Chamber of commerce suggest that while inflation remains elevated, economic growth and the labor market are robust enough to prevent stagflation in the near term. They argue that stagflation – characterized by high inflation, slow growth, and rising unemployment --- does not seem imminent because employment remains strong and growth, while slower, has not changed. With some global regions facing higher risk than others, due to ongoing inflationary and supply chain issues, central bankers and economists are playing closer attention to new dynamics that may change outcomes ---- such as elevated oil price shocks (Similar to the 70s’), geopolitical risks, and extraordinary economic uncertainties. Nevertheless, today these are considered outlier scenarios.
What is Stagflation?
The term - “Stagflation” – first coined in 1965 by a British politician Ian Macleod during a speech to the House of Commons, during a time of economic stress for the United Kingdom.
Stagflation is a rare economic condition characterized by three distinct and troubling features: stagnation, inflation, and high unemployment. In a normal economic cycle, inflation typically rises when the economy is growing, and falls when growth slows. However, during stagflation, inflation continues to rise despite the economy stagnating or even contracting.
The term “stagflation” was popularized in the 1970s during a period when the global economy, particularly in the United States and the United Kingdom, faced this troubling mix of high inflation, slow growth, and rising unemployment. Traditional economic models struggled to explain this phenomenon because inflation and unemployment were previously thought to be inversely related (as described by the Phillips curve). Stagflation upended this assumption, showing that inflation and stagnation could coexist.
Stagflation creates a perfect storm: prices rise, reducing consumers’ purchasing power, while businesses slow production due to weaker demand, leading to layoffs and higher unemployment. This can trap economies in a vicious cycle that is difficult to escape. 70’s Stagflation graph --- below --- is a helpful illustration of patterns and correlations during this period:
What Causes Stagflation?
There is not one simple cause of stagflation; it usually results from a combination of supply-side and demand-side factors. Several key contributors to stagflation include:
1. Supply Shocks: One of the most significant triggers of stagflation is a supply shock, which dramatically reduces the availability of critical goods or services. The 1970s oil crisis is a classic example. When OPEC countries cut oil production, it sent global energy prices skyrocketing, which increased production costs across various industries, resulting in higher inflation. At the same time, the higher costs led to reduced economic output and rising unemployment, causing stagnation.
2. Government Policy Errors: Misguided fiscal and regulatory policies can exacerbate economic woes, particularly if governments introduce price controls, subsidies, or tariffs that disrupt market functioning. In the 1970s, various economic policies in the U.S. and U.K. contributed to worsening inflation during periods of economic stagnation.
3. Rising Costs of Inputs: When the cost of key inputs such as labor or raw materials rises, it can lead to higher inflation even as economic growth slows. Wage-price spirals, where rising wages lead to higher production costs and higher prices, can further drive inflation during periods of stagnant growth.
4. Geopolitical Tensions: Wars, trade disputes, and international sanctions can all disrupt supply chains and raise costs for businesses. In recent years, the war in Ukraine has led to increased energy prices, while trade tensions between major economies have complicated global trade flows.
5. Monetary Policy: Overly loose monetary policy can also contribute to stagflation. When central banks keep interest rates too low for too long, it can fuel excessive demand and inflation. But if an economy is simultaneously experiencing structural issues (e.g., supply shortages, declining productivity), the result can be inflation without corresponding economic growth. Tightening monetary policy later to combat inflation may then slow the economy further, exacerbating the stagnation.
Are We in Stagflation or About to Enter a Stagflation Period?
At present, many economists continue to debate whether we are officially in a stagflationary period. While inflation has been high --- (currently declining), and economic growth has slowed in many regions, unemployment levels have not yet spiked dramatically, which has kept some economists from declaring stagflation outright.
Central banks, including the Federal Reserve and the European Central Bank, have raised interest rates to combat inflation, but doing so increases the risk of recession. Many sectors, such as housing and tech, have already shown signs of strain, with higher interest rates dampening demand. Meanwhile, even considering current interest rates on a declining trend, inflation remains a persistent challenge, --- particularly for energy (possible geopolitical risk), food, labor market tightness and wage growth, and housing costs. If growth continues to falter while inflation stays higher, the conditions for stagflation could be fully realized.
What Types of Investments Do Well During Stagflation?
Investors face unique challenges during stagflation. Traditional asset classes like stocks and bonds may underperform, as companies struggle with rising input costs, weaker demand, and higher borrowing costs, while inflation erodes the value of fixed-income assets. However, certain investment strategies and asset classes tend to perform better during stagflationary periods:
1. Commodities: During periods of stagflation, commodities such as gold, silver, and oil often fare well. Commodities tend to function as a hedge against inflation, as their prices rise in response to supply shortages and rising production costs. Gold is seen as a safe haven asset that preserves value during economic turbulence.
2. Real Estate: Real estate can provide a hedge against inflation, as property values and rents tend to rise with inflation. However, --- investors need to be cautious ---, as higher interest rates have negatively impact real estate prices over the last several years by increasing borrowing and construction costs for developers and consumers alike. Today, Real Estate Prices are considerably elevated in all the industrialized countries and generally out of reach for most consumers.
3. Inflation-Protected Bonds: Treasury Inflation-Protected Securities (TIPS) are government bonds specifically designed to protect against inflation (In Canada we have Real Return Bonds). Their principal value rises with inflation, making them a popular choice for conservative investors seeking stability during stagflation.
4. Defensive Stocks: Companies in defensive sectors such as healthcare, utilities, and consumer staples often perform relatively well during stagflation. These companies provide essential goods and services, meaning they can maintain steady demand even during economic downturns. Their ability to pass on rising costs to consumers helps them maintain profitability in inflationary environments.
5. Dividend-Paying Stocks: Dividend-paying stocks can offer a steady income stream during periods of economic uncertainty. While stock prices may fluctuate, companies with strong balance sheets and consistent dividend payouts provide some cushion against inflation’s erosion of purchasing power.
6. Alternative Investments: Private equity, hedge funds, and other alternative investments may offer diversification benefits during stagflation. Some hedge funds employ strategies that can profit from market volatility or short certain assets, offering protection when traditional markets underperform.
7. Technology companies --- specifically focusing on AI: AI and technology stocks could demonstrate relative resilience during stagflation due to their structural importance and ability to drive efficiency across industries. However, those with high valuations and reliance on external funding could face challenges due to higher interest rates and economic uncertainty. Investor focus should be on AI companies, or companies with a large and strong presence, with strong balance sheets, essential products, and a clear path to profitability, where more speculative or highly leveraged firms may struggle.
Considerations
Stagflation is a rare and troubling economic condition, marked by a combination of stagnant growth, high inflation, and rising unemployment. Today, the risks of stagflation are being discussed because of the unique pressures on the global economy—supply chain disruptions, geopolitical tensions, and central banks trying to balance inflation control with economic growth. While we may not yet be in a full-blown stagflationary period, we need to heed the warning signs. Investors would be wise to prepare and adjust their portfolios as the warning signals intensify. Diversifying into commodities, real estate (Today, very selectively), inflation-protected bonds, and defensive stocks can help safeguard portfolios during this type of challenging economic environment. Understanding the causes and indicators of stagflation, should stagflation materialize, will be critical as we navigate the uncertain economic landscape moving forward.
John
September 2024