What is Stagflation… and why you need to care

Stagflation is an oft unknown term referring to an extremely rare economic crisis that results from an unusual combination of high inflation and low economic growth. It is thought that Iain Macleod, a British politician, first coined the term in a speech to Parliament in 1965 during a difficult time of unemployment and high inflation in the UK.

Saxo’s Chief Investment Officer Steen Jakobsen believes there will be Stagflation Light in the near future, and that this might act as a reset of the global economy. After this (expected) period of Stagflation Light, perhaps there will even an opportunity for a new economic era where the focus should be on the real challenges: better and cleaner energy, a bigger real economy, and much better education and social policies.

What makes it Stagflation “Light

At Saxo, we do not believe in a stagflation like the 1970s, hence the “light” definition, but more of a period of low growth combined with an uptick in unemployment rate and sustained inflation rate around 4% annualised.

However, if this turns into full Stagflation, it could cause unprecedented damage to the global economy that may last for years. As inflation continues to make the costs of living rise and interest rates climb, companies (and families) will have an increasingly higher price to pay for their debts. This could lead to widespread bankruptcy and default, and, inevitably, loss of jobs. We are already seeing an increase in the weight of the debt burden in rising interest rates for credit cards, mortgages and new car loans.

Stagflation and sectors

Peter Garnry, Saxo’s Head of Equities, says,” During periods of stagflation, sectors such as health care, consumer staples, utilities, and energy do well, while sectors such as industrials, real estate, financials, and technology do poorly. In other words, it is precisely the four defensive GICS (Global Industry Classification Standard) sectors that outperform during stagflation compared to the cyclical sectors.

And don’t forget bonds. “As inflation remains elevated and the economy stagnates, Treasury Inflation-Protected Securities (TIPS) provide a hedge against stagflation,’ says Saxo’s Head of Fixed Income, Althea Spinozzi.

Unfortunately, there is no silver bullet that will make stagflation disappear by pushing a button. The two main factors (low economic growth and relatively high inflation) are interdependent. Raising interest rates should be good for bringing inflation down but negative for economic growth. Lower interest rates would be good to give economic growth a boost but might put upwards pressure on inflation. The path that should get us out of this scenario would be increased productivity.

Managing an investment portfolio during times of stagflation can be a challenge. As mentioned by Peter Garnry, putting more weight on defensive sectors and less on the growth sectors will reduce the risk of the portfolio. Also, bonds can play a more important role, given the attractive yields at this moment and their more defensive character by nature. As mentioned by Althea Spinoza, TIPS canprove their value, and the same goes for short-term, high-quality bonds. Another asset class that can be considered to improve the diversification in the overall portfolio is adding (or increasing) commodities.

What can you do

While so much of a stagflation scenario may feel out of your control, you can focus on what is in your control: your asset allocation. Decreasing the risk of your portfolio can be achieved by having more diversification amongst your asset classes, reducing the cyclical sectors, increasing the defensive sectors, and increasing the bond allocation.

You may be wondering what needs to happen for Stagflation to end. Increasing productivity would be beneficial. Further automation, digitization and robotization will play an important role in this. Other measures to raise productivity are increasing Research & Development, innovation and educating employees further. Also improving the mobility of employees will increase productivity.

At the same time governments and central banks have to manage their balancing act between economic growth and interest rates to avoid Full Stagflation whereby inflation could be significantly higher than today and where the unemployment rate will rise dramatically.

We at Saxo will continue to monitor the situation as it develops. Make sure watch this space and tune into our daily Saxo Market Call for ongoing updates.