With inflation on the rise, fears among some experts are mounting of a recession and subsequent stagflation. And with the Bank of England forecasting that things will not to return to normal until 2024, these fears may not be unfounded.
As many analysts have highlighted, stagflation is a pretty unpleasant economic situation to be in. But what exactly is it? How can investors prepare? And can you actually profit from it?
What is stagflation?
Stagflation is an economic cycle during which inflation drives prices higher while the unemployment level climbs. This, in turn, causes consumer spending to fall, resulting in low growth (if any), potentially triggering more job losses.
The last time we encountered this vicious cycle of economic decline was in the 1970s. And it’s a pretty tricky problem for central banks like the Bank of England to solve.
Why? Because introducing new monetary policies to deal with inflation often accelerates unemployment. Meanwhile, policies that deal with unemployment push inflation even higher. And yet doing nothing likely means both get worse. It’s a Catch-22 situation for policy makers.
Causes of stagflation
In the past, stagflation only existed as a theory that many economists considered impossible. And while we know better now, it wasn’t a misguided assumption for the time since inflation and unemployment typically move in opposite directions.
Today we currently have low unemployment with high inflation, creating the perfect conditions for stagflation to take hold. But how did we get here?
Let’s take a look at some of the most common possible causes seen to date.
Poor economic policies
If central banks and governments introduce new monetary policies, taxes, or benefits under poor guidance, it can lead to stagflation.
In 2020, the Bank of England, along with other central banks around the world, issued stimulus cheques to keep the economy going during the height of the pandemic. But with furlough schemes from the government, effective employment levels remained high.
These decisions prevented an economic catastrophe. However, it’s arguably responsible for the threat of stagflation in 2022.
Another potential trigger seen in the past is a sharp rise in minimum wages, taxes, or both. The increase in labour costs paired with higher taxes forces businesses to start raising prices and, in turn, causes inflation.
Alternatively, monetary policy makers may fail to increase the interest rate when an economy is nearing full capacity. This leads to a short-term consumer boom sending economic growth through the roof. But it ultimately causes rising prices, triggering higher inflation even when unemployment is low.
In extreme circumstances, this can lead to a “wage-price-spiral” where employees demand higher salaries, causing higher prices, causing salary demands to increase, eventually triggering job losses. The end result is high inflation, high unemployment, and flat economic output — stagflation.
Sudden supply chain disruptions
The sharp increase in commodity prices due to supply chain disruptions can lead to devastating effects if they aren’t resolved quickly.
Most enterprises producing physical products need raw materials like oil, lumber, and metals. Therefore, price spikes force businesses to pass on the cost to consumers, causing prices to rise. If these higher prices continue, businesses will eventually need to cut costs through through wage cuts or job losses.
Both scenarios cause disposable household income to suffer, triggering a slowdown in consumer spending. Non-essential discretionary items are cut from the shopping list in favour of food, utilities, and healthcare. In response, businesses lower production output to keep costs down, causing economic growth to stagnate.
Out of all the stagflation causes, this is arguably the easiest to solve. Most of the problems evaporate once supply lines are restored.
The UK actually went through supply-shock stagflation in 2010, following a surge in oil prices. The supply chain was restored in April 2011, causing prices to fall and ending stagflation by 2012.
Removal of the Gold Standard
An often-overlooked stagflation trigger was a decision made by US President Nixon. After the end of the 1944 Bretton Woods system, the US dollar was no longer backed by a commodity like gold or silver.
While this provides central banks far more flexibility in their policy decision-making, it also removes restrictions and constraints on monetary expansion and currency devaluation. In other words, this makes it easier to accidentally trigger stagflation through poor economic policies.
What about in the UK? Well, the Great British pound hasn’t been backed by commodities since 1931. Therefore, the Bank of England also lacks these protections.
What caused stagflation in the 1970s?
The economic crisis in the 1970s was a pretty complex mess. In oversimplified terms, it was a combination of all three previously mentioned causes.
The US government’s decision to engage in the costly Vietnam war, paired with a simultaneous surge in social spending, caused the federal budget deficit to swell. With the US dollar backed by gold, the Federal Reserve was limited in its ability to control monetary policies. And this ultimately led to the removal of the Gold Standard in America.
Later in 1973, the Organisation of Arab Petroleum Exporting Countries (now OPEC) announced an oil embargo against countries that supported Israel in the Arab-Israeli war. That list included both the United States and the United Kingdom.
This triggered an oil supply shock that caused prices to more than triple in a short space of time. The situation worsened when the US deployed its own oil embargo against Iran towards the end of the decade. Energy bills skyrocketed, triggering multiple recessions and sending unemployment through the roof while inflation kept climbing.
It wouldn’t be until the early 1980s that this period of horrific stagflation would come to an end.
How does stagflation affect your investments?
It’s evident that stagflation is bad news for consumers. But what does it mean for investors?
If the UK economy enters another period of stagflation, an investment portfolio could be severely impacted. With monetary policies seeking to tackle rising inflation with interest rates, the cost of raising capital will rise.
Debt will become more expensive, and with investor fears driving down stock prices, using equity to raise funds is far from ideal. That’s pretty bad news for high-growth stocks still dependent on external financing. And even the businesses that have become self-sustaining could struggle to deliver growth as consumers tighten their spending habits.
That’s why stagflation typically causes stock prices to fall. However, not all industries are as adversely affected. Defensive investments are likely to outperform. This typically includes all the essential market sectors providing products and services that households cannot realistically cut. Examples include utilities, healthcare, real estate, and consumer stables.
Is stagflation worse than a recession?
Stagflation and recessions share a lot of traits. Yet the former is considered far worse given the difficulty of solving it.
A central bank has multiple levers at its disposal to control the money supply moving in and out of an economy. This is an indirect way of controlling unemployment and inflation. The problem is that improving one makes the other worse.
Typically, a recession has rising unemployment, slow economic growth, with low inflation. In contrast, stagflation has high unemployment and low economic growth, but high inflation.
Reducing unemployment will stimulate economic growth but cause inflation to rise even higher. Reducing inflation causes unemployment to get worse and economic growth to grind to a halt.
Needless to say, it’s not an easy problem to overcome.
Is the UK economy heading for stagflation?
Our current economic environment is seeing slowing economic growth with high inflation, yet unemployment remains low. It’s a strange combination that sets the stage for stagflation to materialise.
This risk is made worse by the supply chain disruptions that Covid-19 caused, as well as the ongoing war in Eastern Europe. And for the UK in particular, Brexit continues to create a growing labour shortage in agriculture and logistics. Consequently, economic output was already declining before fears of stagflation started to emerge.
Pairing this with skyrocketing energy prices has led to many experts drawing parallels between 2022 and the 1970s. If that economic crisis were to be repeated, the stock market could be in for quite a volatile ride.
Having said that, it’s important to keep things in perspective. Despite the similarities with the 1970s, data from the Office of National Statistics show the British economy is vastly different today, with far less dependence on commodities.
The British manufacturing sector, which consumes the bulk of produced and imported raw materials like wood, metals, and oil, has shrunk by nearly 70% since 1970. This is primarily due to the evolution of a service-based economy. Meanwhile, with renewable energy infrastructure continuing to expand, the UK’s dependence on gas has fallen by over 25%.
This suggests that if stagflation does rear its ugly head, the impact will be far less severe than in the 1970s on a supply-shock basis. As for the effects of monetary policy, that’s more difficult to predict.
It’s too early to determine whether or not stagflation will appear in the UK economy. However, in the worst-case scenario, the evidence we currently have suggests the impact won’t be as severe as many are speculating. And even in the Bank of England’s bleakest forecast, inflation is expected to return to the ideal target of 2% by 2024.
How to invest during stagflation
The disruptions and volatility caused by stagflation can trigger a lot of panic selling and mass migrations of capital between different asset classes. This can be immensely troublesome or profitable for short-term traders depending on whether they can accurately predict shifting behaviours.
However, as a long-term investor, not much changes with how you should invest. Yes, it’s unpleasant to watch positions suffer double-digit declines. But providing an investor holds high-quality companies with strong balance sheets and proven business models, most portfolios will be able to weather the storm.
Having said that, the last couple of years have perfectly demonstrated how disruptive unpredictable external factors can be, even on top-tier industry leaders. Therefore, diversification during stagflation is even more crucial.
Stagflation is an economic cycle during which inflation and unemployment climb while economic growth slows.
With inflation driving up raw material costs, homebuilders often pass on the increased expenses to customers, causing house prices to rise. This is why real estate investments tend to outperform during times of stagflation.
However, this boost may be short-lived as central banks boost interest rates to bring inflation back down. The rate hikes can cause affordability to drop, causing home prices to eventually reverse.
With investors shifting capital into defensive investments like gold, the metal tends to outperform other asset classes during times of stagflation.