“Stagflation” is a term that has been picked up in the media a lot in recent months. “Stagflation” refers to persistent high inflation combined with high unemployment and stagnant demand in the economy. The general consensus is that stagflation is caused by cost-push inflation, which occurs when a shock to the economy, such as the recent sharp rise in energy prices, causes the costs of production to increase. This then feeds through to the economy and the consumer. It is an economic scenario that was first identified (and experienced) in the 1970s.
Why is stagflation so bad for the economy?
With stagflation, the extended period of slow economic growth is combined with high rates of inflation. Inflation is the ongoing rises in prices for goods and services, but it can also be described as a continuing fall in the buying power of money. In a normal year, inflation might rise two or three percentage points. If the rate of inflation begins to rise past 5% this can have major economic impact.
This is why stagflation is such a threat to the economy. In a scenario in which you have both a depressed economy and high inflation, combined with high unemployment, consumers have less money to spend. If inflation runs rife, then the money consumers do have is worth less every day. If you're on a limited income this can have dire consequences. Further, if you have savings, inflation reduces its value, too. Inflation reduces consumer confidence in an already depressed economic environment. This also puts the monetary authorities in a difficult position, as they want to increase interest rates to control inflation, but increasing interest rates could depress the economy further.
How can I adjust my investment strategy to manage the potential risk posed by stagflation?
Investing in anticipation of stagflation is not an easy subject to tackle; there is no clear consensus on the best approach to attempt to mitigate the risks associated with this potential economic scenario. One possible strategy is to increase exposure to commodities such as precious metals, industrial metals, natural resources or agricultural goods. The increases in the cost of these commodities are often the root of the cause of the “push” part of the inflation growth.
The impact on “core” investment markets is not clear cut. Bond markets can suffer if interest rates are increased in an attempt to control inflation. But government bonds could also benefit if there is a flight to safety, for example, if investors are concerned around the potential for falls in stock markets. The link between equity returns and inflation is debated but, in a period of stagflation – and, therefore, stagnant growth – equity markets are likely to suffer due to investors perception that the economy in general will be in a downturn.
The key to investing in such a potentially difficult situation is to manage your risks. You should look at your interest rate and inflation hedging level to see whether you have a suitable level of hedging. You should also look to have a diversified approach to your investments, spreading risk across different asset classes and looking to your managers, for example in diversified growth funds, to get you access to real assets such as natural resources and those other assets that increase in-line with inflation. This could also include other real assets such as property and infrastructure.