There is a growing concern that investors need to get ready for stagflation: that unwanted mix of high inflation and low or no growth in the economy.
For equity investors this could create a gloomy outlook, the asset class has been the worst-performer in previous stagflationary periods.
World Bank president David Malpass has set the scene. “The war in Ukraine, lockdowns in China, supply-chain disruptions and the risk of stagflation are hammering growth. For many countries, recession will be hard to avoid.”
The World Bank noted that the recovery from stagflation in the 1970s required steep increases in interest rates in advanced economies – a road we seem to be heading down – which then played a prominent role in triggering a string of financial crises in emerging market and developing economies.
The World Bank also observed that if inflation remains high – and expectations are that it will – a repeat of the earlier stagflation episode could translate into a sharp downturn along with financial crises around the world.
This time it’s different
This presents a serious scenario for investors. But if stagflation is the coming spectre, investors can take comfort in a so-called “stagflation playbook”.
This suggests a focus on stock market sectors that typically benefit from inflation, like energy, along with defensive stocks like real estate and healthcare.
Such a playbook idea has proven correct thus far, despite the falls in the market, with energy the only sector that reported positive returns in the first half of 2022 at 28%. Investors should take note.
Jose Pellicer, head of investment strategy at M&G Real Estate, set out how the current reality compares to the idea of dealing with stagflation, playbook style. “Defensive sectors such as food stores and some residential assets with lease structures where inflation flows through to rental cashflows are typically well positioned against stagflation in the medium term,” he said.
However, he fired a warning. “Real estate assets, which have poor ESG ratings, such as older office and shopping centre stock, or sectors carrying supply risk, will be less resilient to stagflation.”
And when stagflation last occurred in the late 1970s, real estate offered some inflation protection. But this no longer applies. “Today the market is more nuanced and not all properties are well placed to deal with the threat of stagflation,” Pellicer said.
“Another factor real estate investors must consider is that leverage was not widely used for property investments back in the 70s and 80s,” Pellicer added. “Now it is commonplace, and investors must think about what happens when refinancing costs increase in a highly-levered asset with weak rental growth prospects when stagflation hits.”
Looking for quality
Contemplating the situation going forward, Pellicer added: “In the longer term, for higher-risk investors, as interest rates stabilise there will likely be plenty of value-add opportunities where they can deliver strong returns.”
Looking at other sectors, oil and gas companies produced good profits as commodity prices have soared. A question mark here is whether oil is still worth a punt, as its price has dramatically fallento earth.
Stagflation is also a potential problem for tech. Growth stocks in that sector have consistently been the worst performing during previous periods of stagflation.
The focus should instead, according to the stagflation playbook, be on quality, value and dividends. As an indicator, companies that have consistent earnings and low debt-to-income ratios are typically ranked higher in S&P Global’s “earnings and dividend quality” ranking system.
Defensive streams
There are other challenges for investors. “The issue with inflation as an investment risk is that it is difficult to hedge,” said market commentator Stuart Trow, formerly of the European Bank for Reconstruction and Development. “Even explicit inflation hedges are imperfect and apt to fail altogether on occasion: look at index-linked gilts.”
Over the longer term, owning defensive assets is the best counter to the purchasing power of money falling, although the short-term correlation is often weak, Trow added. “Strong defensive income streams help, which is why the FTSE100 has held up relatively well – many of its stocks have steady, defensive income streams in strong currencies, such as the dollar.”
For Trow, a potential stagflation situation shows the importance of international and sectoral diversification. “Many institutional funds would have been underweight the UK due to the poor economic outlook, but with growth stocks on the backfoot, it has come into its own to a certain extent.”
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