What is stagflation and how do you trade it?

The spectre of stagflation is raising its head. What is it and what should you do to be prepared for its impact? Learn more here.

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What is stagflation?

Stagflation is defined as ‘persistent high inflation combined with high unemployment and stagnant demand in a country's economy,’ a term first used in the UK in the 1960s.

While inflationary environments are often accompanied by economic growth and a decrease in unemployment, economic stagflation means that few of the benefits of inflation are realised while the dangers of a stagnant economy make it difficult for countries to move back onto a growth trajectory.

What causes stagflation?

Stagflation is caused by negative economic factors combining to create an environment where countries or regions can struggle to return normal economic activity. These factors are:

High inflation

While periods of low economic growth often see inflation slow at the same time, during stagflation prices continue to increase at an accelerated rate.

This can be triggered by the price of commodities, whose price is set globally and is therefore outside of the control of national governments.

During the 1970s, inflation caused by a surge in the oil price triggered a global economic crisis. Because of the importance of oil across industries prices increased, almost universally. This was not countered by economic or jobs growth, resulting in a reduction in real spending power.

High unemployment

Inflationary environments are often caused by increased consumer spending as demand outstrips supply. However, stagflation is often accompanied by higher unemployment or flat jobs growth. This means that even though prices are increasing, this isn’t accompanied by similar growth in consumer spending.

Low economic growth

As economic activity slows, and prices increase consumers focus their limited spend on essential items. This has a chilling effect on suppliers of goods and services as the reduction in overall expenditure puts pressure on all aspects of the economy.

This combination of factors makes it challenging for economies to recover, with the effects often felt years after the initial triggers have ended.

What assets tend to perform better during stagflation?

Just as there are asset classes that perform well during times of strong economic growth, there are some assets that are more resistant to the ravages of stagflation. Some of these are:

Bonds

In a market where traditional investment options underperform, bonds offer a relatively safe haven for investors.

Inflation-linked bonds, which in recent times have been priced with a negative yield, offer stable returns during times of high inflation. There is a risk of having to pay a small yield should inflation remain low, but if the inflation rate rises the returns are linked to the consumer price index (CPI).

High-yield nominal bonds, especially junk bonds, and emerging market bonds offer higher returns, although at a higher risk. Favouring junk bonds that are likely to benefit from a recovery in key markets is key to leveraging these.

Emerging market bonds traditionally offer higher returns, but they typically lag developed markets in a return to normal economic activity.

Sovereign bonds and bonds with long durations should be avoided.

Commodities

While economic activity slows during a period of stagflation, commodity prices benefit from the inflationary pressures on the market. With producers potentially scaling back production and a global marketplace, key commodities usually see prices rise during periods of stagflation. However, higher prices have the effect of depressing economic activity and prices will decline once a balance between supply and demand has been reached.

Core consumer stocks

As consumers feel the pinch of higher prices and lower levels of disposable income, spending is refocused on staple commodities. Companies providing these products, including healthcare providers, energy companies, food retailers and producers, could see their share of the market increase, resulting in continued market support. Even higher-end retailers capable of refocusing their strategies can provide opportunities during these periods.

How to trade stagflation

Using the above categories, traders can balance their portfolios by simply diversifying into these categories, reducing their exposure to higher risk assets, and moving into assets that will weather the stagflation storm better.

High-performing stocks are likely to weather any stagflation well, especially technology companies whose services are likely to increase in demand as people restrict additional activities and spend more time online.

Identifying stocks that are likely to be hard hit by a stagflationary environment also provides a trading opportunity, shorting those equities can provide a strong hedge against a market that is underperforming.

As the market starts to correct and return to one where inflation and growth are within normal bounds those companies who have been negatively impacted but who will see the benefits of the recovery offer real opportunity.

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Deflation vs stagflation: what are the differences?

Many investors look at the concept of stagflation vs deflation and confuse the two trends.

Deflation can often act as a precursor to stagflation. A deflationary environment sees prices decline, as opposed to stagflation where prices increase.

The decrease in prices often sees company performance reduced, followed by cuts in headcount to minimize costs. The decrease in employment can drive trigger further deflation as consumer spending contracts.

In a deflationary environment, consumer spending is further constrained by the expectation that ‘things will cost less if I wait’. This compounds the pressure on companies and can drive up unemployment.

Stagflation, on the other hand, sees prices increasing, with high unemployment already a part of the equation, as opposed to a side effect of it.

Stagflation summed up

  • The combination of high inflation, low growth and high unemployment is devastating, but uncommon in developed markets
  • Central banks and governments tend to act aggressively to head off the tell-tale signs of stagflation
  • Traders need to remain vigilant and have plans in place to adopt alternative strategies should stagflation raise its head

Publication date : 2021-10-14T06:11:15+0100

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