Are we heading towards “Stagflation”?

Oct 25, 2021

Welcome to Finance and Fury. Currently, the prospect of stagflation is being seriously debated by economists and policy makers across most economies – the big question is – will we suffer stagflation – and if so, how do markets react?

1. The first stages of an energy crisis are currently in the making - In Europe - natural gas prices have tripled in the last three months – with rising petrol prices across the globe – even in Aus, petrol prices are up –
   1. Why do energy prices matter and what does this have to do with stagflation? Energy is an input into everything – transportation, manufacturing, even keeping office lights on – all of this flows through into increasing prices over time
   2. Coupled with this – annual CPI currently is sitting at 5.3% in the US, 5.8% in Poland, 7.4% in Russia and 9.7% in Brazil – even Aus is at around 3.8% - so all countries are sitting above their target rates – the countries suffering the most severe inflation are those suffering from supply shortages
   3. The major concerns are that these energy spikes in conjunction with supply shortages will lead to lasting inflation – and due to the potential of slowdown in economic output (which is also related to the supply shortages, leading to less economic activities) – economies have the potential to enter a stagflation situation
2. Stagflation was a phenomenon that plagued the economies of the world back in the 1970s – you had an energy crisis, with soaring prices, which had flow on effects to every sector –
   1. You also had slowing economic growth, where a few quarters in the mid-70s hit negative GDP growth rates - and there were accompanied with higher levels of unemployment – and due to energy prices, massive levels of inflation

Defining stagflation – what does this actually mean?

1. Relating the term stagflation simply to the economy of the 1970s is a little too simplistic – just saying that it is a time where there is inflation, lowering GDP, a wage-price spiral and high unemployment doesn’t quite define the issue at hand
2. This is because the issue is, there is no hard definition of stagflation when it comes to the metrics involved with the actual definition – i.e. how much inflation needs to be present, and what does the growth rate of the economy need to be to equate to stagflation – so here are three broad definitions for stagflation that can narrow this down
   1. Growth around zero or negative, and inflation well above target
   2. Growth below trend and inflation comfortably above target
   3. a strong slowdown in growth and strong pickup in inflation
3. Out of these, instead, what if we say that ‘stagflation’ is a period where inflation expectations are rising above the central bank target rate and growth is slowing and is below trend (i.e. expected to drop below growth forecasts)?
   2. This is a softer definition and much easier to apply – if inflation reaches a rate of above 3% and is expected to climb higher, and economic growth, as measured by GDP is forecasted to be 3% but turns out to be 2.5%, i.e. the forecasted nominal rate – then do we meet stagflation? I would say that this would be a situation where an economy would be in a stagflation environment
   3. There’s just one problem: when compared to the economic environment of the 1970s - looking at the current state of the economy, things are a little different
4. Where then do markets actually sit? Look deeper at inflation expectations and GDP growth
   5. To start with – looking at the US – inflation is high – at a 13 year high at around 5.4% - However – the US manufacturing Purchasing Managers' Index(PMI) has risen over the last two months whilst inflation rates have remained the same over this time period
      1. The PMI is an indexof the prevailing direction of economic trends in the manufacturing and service sectors – if this is on the rise, then it is expected that the costs for manufacturing and services is expected to increase – this leads to further inflation expectations down the road
      2. In Australia – The PMI has dropped heavily since July – so we seem to be doing better than the US – with lower potential inflation outbreaks

• Scenarios of slowing growth and rising inflation clash with most forecasts - recent moves in inflation expectations, especially in the US are a bad situation – but growth doesn’t seem to be slowing at this stage – especially when compared to how the 1970s played out

1. Over the past 18 months - GDP growth rates have gone through negative downturns – most western economies saw around three quarters of GDP growth rates – but will this continue?
   9. Well no – they rebounded rather quickly – US GDP dropped by around 9.1%, then sat at -2.9% and -2.5% over the next quarters respectively, but then rebounded to 12% growth – this 12% is a rebound from the bottom – so will calm down in terms of growth rates – but what is more important is the nominal level of GDP – this is sitting at about $20.9trn, from the peak in 2019 of around 21.4trn – or a $500bn loss
      1. Australia’s GDP actually peaked back in 2012 at just shy of $1.6trn – crashed by 2016 – then recovered – but still lower at about $1.3trn
   10. But the question is, will growth rates revert back to negative – or below forecasted growth?

• It doesn’t appear to be the case at this stage – not when growth forecasts have been slightly downgraded – to explain this further – if say you expect annual GDP to be 1.5% p.a. and it grows by 1.6% - this is a great result – because it is above forecasts – but is it really? Not if inflation is around 5% for the long term

6. In Australia – Growth has rebounded after a negative growth period – dropped to negative 6.2%, then sat at -3.7% and -1% over the next quarters respectively rebounded to 9.6% in the second quarter of 2021

1. Where we are sitting – if growth can pick back up – and maintains a positive position – and the last quarter of rebounded growth wasn’t just a once off that helped to mitigate the negative period of growth – then the only concern is inflation, not stagflation – but the risk to financial markets still remains – But many economists predict that growth with stagnate from here - stagflation is economists’ base case expectation - even though many have cut their GDP forecast while hiking their inflation outlook –

5. Because to add another element to this issue - Asset pricing also couldn’t be more different between now and the last episode of stagflation in the 70s
   1. When looking over the 100 years – ever since the Fed was created - the 1970s represented the lead up to an all-time high for nominal interest rates that occurred in the 1980s - and an all-time low for equity valuations – had nominal rates in the US
   2. Comparing this to the markets today – we are at all-time lows when looking at both nominal and real interest rates – whilst witnessing all-time high valuations for almost every asset class – property, equities, fixed interest, even commodities – gold, copper, etc. 

 

Historically - How do shares perform during stagflation – Spoiler alert: it isn’t great

1. in situation where stagflation does emerge – you seeweak historical performance of most equities – this is why even the term stagflation can freak out investors
2. This being said - equity investors who are active today have likely had little experience with stagflation first hand – it would be rare to find an active investor who was participating in markets back in the 1970s -
   1. since 1960 – there have been 41 quarters (17% of this time period) that have met these criteria, but the vast majority of those occurred between the late 1960s and early 1980s – since the 2000s - stagflation has been virtually non-existent
      2. Over this time period - the S&P 500 has generated a median real total return of +2.5% per quarter – however in these stagflation quarters, the average return per quarter fell to -2.1% - This is actually worse than the returns when you had either weak economic growth or high inflation by themselves
      3. Most of this weakness during stagflationary environments has been attributable to pressure on corporate profit margins – due to inflation, declining profit margins and real earnings have been incurred, which indicates that companies struggled to raise prices quickly enough to offset rising input costs - P/E multiples have also declined modestly during stagflationary periods alongside rising interest rates.
   2. Another issue with the market compared to the 1970s and now is the amount of debt that corporations have – It was hard to try and find accurate data on this going back this long, best was the 90s – but the BIS did release a paper showing that as a % of GDP, corporate debt in the US has gone from about 40% to 80% from 1970 to 2020 – in addition, household debts are through the roof -
   3. Why does this matter? inflation is already showing up and impacting monetary policy.In just the last three weeks, many central bank rates have increased their interbank cash rates - 25bp in New Zealand, 25bp in Russia, 50bp in Peru, 50bp in Poland, 75bp in the Czech Republic and 100bp in Brazil – beyond NZ, each of these countries are already suffering high levels of inflation
3. One final reason why markets can take a downturn during stagflation periods could be due to the wealth effect – i.e. not just economic growth declines but also the declining growth of household wealth – this can become its own self-fulfilling prophecy – if people are expecting tough times, or going to need additional cash/funds – they sell assets – which drops asset prices
   1. Household net worth has grown by a median real rate of 0.5% per quarter since 1960, but just a 0% rate during periods of stagflation.These periods have also been associated with declining household allocations to equities, helping explain the weakness in equity valuation multiples. Home prices have typically declined in real terms during stagflation while gold has appreciated.

 

 

Who are the winners and losers during stagflation?

1. Nobody is really a winner in this environment – the population suffers due to monetary policy, the prices of goods increasing and growth slowing, leading to potentials of job losses
   1. When looking at shares – some perform better than others - Who are the winners in this scenario
      1. Looking at sectors - Energy and Health Care have typically generated the strongest returns during periods of stagflation. That may explain why during the past month, Energy has been the strongest sector in the market, rising by 14% alongside an equivalent surge in crude oil
      2. Healthcare may just be a coincidence – or simply be able to reprice better than other sectors – but energy makes a lot of sense – when energy prices go up in stagflation environments – energy companies can made additional revenues – therefore a good hedge has been energy providers in this environment
   2. Who are the losers - Industrials and Information Technology have generally lagged most during stagflationary environments - IT sector is less cyclical now than it was during the stagflationary years of the late 1960s to early 1980s due to the compositional shift toward software and services firms. Today, however, the sector’s massive long long-term growth profile has given it a longer “duration” than most other equities, making it particularly sensitive to real interest rates
      1. It is estimated by investment banks like Goldman that a 0.3% increase in the cash rate would knock some 15% off tech stock prices
      2. For industrials - construction and engineering, infrastructure, transport and commercial services – many of these are sensitive to interest rate costs due to financing for capital expenditure

• Both of these sectors are sensitive to interest rate rises which would occur if central banks aim to combat inflation

The biggest question when it comes to stagflation – will the high inflation be temporary? It is almost a given that growth will be low – low in the terms of nominal rates – but if inflation is too high, then real growth may be near zero or negative

 

In summary – The market is focused on stagflation; it just hasn’t quite decided what that term really means

1. Where we currently stand – many view the surge in energy prices as temporary, and that the most comparable period to the current stagflationary scare is more comparable to 2005 when CPI hit 3.5%, energy prices were booming and Stagflation was in the news a lot – it even graced the cover of The Economist - These fears eventually passed as growth rebounded and inflation moderated - so 2005 may provide a useful reference point for a scare that comes far short of the 1970s
2. My "gut feel" is that while risks to financial markets are high, due to monetary policy responses, especially on the inflation side, the phrase “stagflation” is being used too aggressively at the moment – time will tell
3. We don’t appear to be in this sort of environment – the economy isn’t looking great – many assets are overvalued – growth is lower than the average of a decade ago, and inflation expectations are rising –
   1. But the risk of stagflation don’t appear to be present at this stage looking forward over the next 12 months
   2. If you are concerned about stagflation – the best play historically has been energy shares and precious metals, like gold – this isn’t advice – but just general information based around historical occurrences
   3. But the trouble with energy is that it is cyclical – once the fears of stagflation blow over – or even if stagflation hits – once the decline to the market takes place, then energy shares tend to lag the next cycle of the market

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