28th October 2021.
Worries about stagflation have come to the fore recently as supply bottlenecks threaten to keep inflation elevated even as economic growth slows. While the consensus amongst policymakers is current inflation will be transitory, some investors are starting to worry about a return to the stagflation of the 1970s.
That may be an overreaction: the global economy, is projected to grow by 5.9% in 2021 and 4.9% in 2022 according to the IMF. However, fuelled by easy money, financial markets are priced for very favourable macro conditions as reflected in high P/E multiples and tight credit spreads.
The possibility of a regime shift towards even moderately higher inflation, if not the stagflation of the 1970s, could have significant implications for asset allocation.
The inflation-deflation debate
The debate around inflation has been particularly contentious since the outbreak of COVID-19. What made COVID unique was that it was a supply shock (factories and business shut because of lockdowns) and a demand shock (people had less opportunity to consume services) for the economy.
While much of the debate centred around whether record amounts of monetary stimulus would generate stronger demand, fuelling inflation, in the last few months it has been supply side bottlenecks that have driven inflation.
What is interesting is these bottlenecks have emerged across multiple dimensions – reduced labour supply, production outages, chip shortages, higher energy costs and distribution challenges – making it more difficult to assess whether higher inflation will be transitory.
Assessing supply side disruptions
In Europe a shortage of truck drivers is disrupting the flow of goods through the economy. In the US, the “Great Resignation” has seen millions leave the labour market following COVID: in August, 4.3 million workers voluntarily quit, the most in two decades.
Insufficient supply of semiconductors, has led to shortages of new cars and some electrical goods, increasing lead times and pushing up prices.
In September the focus shifted to a third supply constraint, the cost of energy, as natural gas prices soared in Europe. The oil crises of 1973 and 1979 are the textbook examples of adverse supply shocks, so when energy prices rise sharply, stagflation fears intensify.
In China rising energy costs, particularly coal, have led to power outages and production cuts. Many local governments are behind on meeting carbon emission reduction targets and are now trying to catch up by forcing factories to stop production to constrain energy usage.
Rising distribution costs and longer distribution timelines are also a challenge as ports are clogged with container shops. Nike recently reported that moving product from Asia to North America takes 80 days, double the normal time.
The difficulty for investors is the many of these factors are inherently unpredictable. Will all the people who resigned in the Great Resignation go back to work after taking a year out? If we get a mild winter, will natural gas inventories be refilled? How will Beijing manage the twin challenge of meeting emission targets and managing the deleveraging of the real estate sector?
Implications for asset allocation
Asset allocators may need to balance having protection for higher inflation while being cognisant that the recent higher levels may be transitory. Market performance in September gave a sample of how difficult asset allocation may become if inflation is sustained: both equities and government bonds posted losses on the month.
Government bonds are the obvious loser in a period of higher inflation given current historically low yields. In theory equities should hold up in an inflationary environment as shares are a claim on real assets.
Nevertheless, when inflation rose sharply in the early 1970s global equities entered a bear market and the net effect was real equity returns of -1.5% p.a. in the US and -2.6% p.a. in the UK over the decade (Deutsche Bank Long Term Asset Study). Those returns compounded to a fall of 23% in real wealth for UK equity investors.
The global economy is different to the 1970s in many ways (less unionization, more flexible markets, the Bretton Woods fixed exchange rate system was still in place in the early 1970s etc) so a direct parallel with that period may be misguided.
However, valuations for bonds and equities are more stretched now than they were at the start of the 1970s so the risks to financial assets may now be greater. Back then US 10-year yields were about 7.5% and Robert Shiller’s cyclically adjusted P/E ratio for the S&P 500 was just over 17 versus the current level of 38.
Financial markets have gotten used to ongoing central bank asset purchases. If inflation stays stubbornly high it may force central banks to unwind stimulus measures which would be a headwind for financial assets, as we saw in 2018. Therefore, it may make sense both to diversify equity risk and include a wider range of assets and strategies for diversification rather than relying on government bonds.
While corporate bonds may seem obvious alternatives to government bonds, given their ability to generate income, yields have fallen significantly over the last decade, reducing prospective returns. Taking on more credit risk via high yield or emerging market debt can add more income but may also add to the equity beta of the portfolio as historically these assets have not performed well during equity bear markets. Inflation linked bonds may be worth considering as the coupons automatically increase as reported inflation rates rise.
Although gold has struggled this year even as inflation picked up, it did perform strongly in the 1970s and tends to rise when real yields fall (often driven by higher inflation). However, the rise of crypto currencies have arguably diverted some fiat money sceptics from gold to Bitcoin and other digital assets. Real assets like property, land or even collectibles tend to offer inflation protection and could be part of a portfolio if liquidity is less of a consideration
Hedge fund strategies offer a more liquid alternative. When considering hedge fund allocations it is important to differentiate between strategies that have an inherent equity market beta (e.g. equity hedged) and those that can deliver returns when equities fall. Strategies more focused on commodity trading and that can be long or short across markets may have more potential given the more volatile macro backdrop.
In summary, a return to the stagflation of the 1970s may not be the correct historical analogy. But financial assets have had a tailwind of low inflation and monetary support from central banks for over a decade which looks less likely to be sustained for the next decade. Being diversified across multiple risk factors seems even more important when considering asset allocation for the coming years.
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