Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn
About

News

Explained: What is stagflation and how to play it

Lewis Jackson  |  11 Mar 2022Text size  Decrease  Increase  |  
Email to Friend

A surge in commodity prices at a time when inflation is running hot across the globe has market commentators discussing the return of stagflation: A combination of rising prices, high unemployment and slow growth not seen for decades.

The last time the world endured the mix was in the 1970s and 1980s. Then, wars and revolutions in the Middle East sent oil prices spiraling, helping trigger double-digit inflation, pushing millions out of work and causing deep recessions across the developed world.

Today, a combination of record commodity prices, loose monetary policy and high inflation is leading some to warn stagflation could return.

“Today is not that different [from the 1970s]. Economies grow until they don’t. That was true in the 1970s and it’s true now,” says Stephen Miller, an investment strategist at GSFM funds management.

“At the moment, things look ok, but there are reasons to be worried. I’m not saying this is necessarily a rerun, but there are eerie parallels.”

We spoke with several analysts about stagflation, how it could return, whether Australia is at risk, and how to position portfolios for the possibility.

Federal Reserve Chairman Paul Volcker and President Ronald Reagan in the Oval Office

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

How does stagflation occur?

The defining characteristic of the 1970s economy, stagflation came as a surprise to people at the time, says Miller. Economists define stagflation as a period where inflation is high, economic growth slows and unemployment is stubbornly high.

Commodity price shocks are key to the emergence of stagflation, he says. The 1973 Yom Kippur War and then the 1979 Iranian revolution caused US oil prices to rise from US$3 to US$32 over the decade. Inflation jumped as everything from transportation to heating became more expensive. Growth took a hit as higher fuel prices left consumers and businesses with less to spend.

“Households having to spend more money on filling their fuel tanks, or money heating and airconditioning their homes, have less money for anything else,” he says.

Temporary shocks become permanent when businesses respond with higher prices and workers demand wage increases in an escalating cycle. Australian inflation rose from 10% in March 1970 to 25% by the end of the decade. Business margins and wages get squeezed by rising prices. People have less to spend and businesses cut employment and investment, says Miller.

“There’s this vicious circle between crimped household income, crimped business income, crimped employment and higher prices and higher wages,” he says.

Central banks initially failed to tighten monetary policy quickly enough or for long enough to rein in prices, he adds. It took the “Volcker shock”—a jump in interest rates to a peak of 20% in 1981—by then Federal Reserve Chairman Paul Volcker to bring inflation under control.

Could it happen today? Opinions are divided

With today’s high inflation, the dizzying jump in commodity prices and record low-interest rates, you have the material for a return of stagflation to Australia and the developed world, says Miller.

He paints a scenario where the commodity price shock from Russia’s invasion of Ukraine stokes inflation already running at decade highs—Australian inflation hit its highest level since 2011 last December as petrol prices jumped at the fastest rate since 1990. If policymakers are too slow to respond, then a growth-destroying price spiral could take off, he says.

“The orders of magnitude might be different because Australia has a lower [inflation] starting point [than the US]. That doesn’t mean it can’t go up because households and businesses are subject to the same pressures associated with rising energy prices and rising commodity prices,” says Miller.

David Sekera, chief US markets strategist at Morningstar, is more sanguine about the risk. In the US case, growth is still robust, and Morningstar forecasts GDP to grow at 3.7% in 2022. He expects inflation to subside this year as supply chain bottlenecks ease and consumers switch spending from goods to services.

“Stagflation is a very low probability event from the perspective of economic growth languishing or inflation being persistent,” he says.

Today’s world also differs from the 1970s in three respects. Weaker trade unions and less regulated labour markets mean wage growth may not accelerate as in the past, acknowledges Miller. Slow wage growth is a point Reserve Bank Governor Philip Lowe repeatedly highlights. He maintains the bank is holding off on rate hikes because wage growth remains below the bank’s target of 3%.

Central banks also have the policy mistakes of the 1970s and 1980s as a guide. In testimony before Congress last week, Federal Reserve Chairman Jerome Powell praised Volcker as the “greatest economic public servant of the era” as he pledged to do whatever it took to rein in inflation. Governor Lowe similarly committed the bank to doing “what is necessary” to maintain low and stable inflation in comments on Wednesday.

Consumer spending could also prove more resilient to higher energy prices today than in the past. New research from Oxford Economics argues trillions in excess savings from the pandemic and a buoyant employment market could partly offset the impact of higher energy prices in the US.

Spending on gasoline and other energy products as a share of all consumer spending sits at about 2.5% in the US today, compared to around 6% in the early 1980s, according to data from the US Department of Commerce

Investing in a stagflationary environment

Wide moat equities, commodities, certain sections of the real estate market and gold are all options in a stagflationary environment, say analysts.

“It’s hard to hide in a stagflationary environment,” says Sekera. “Fixed income loses purchasing power because interest rates often don’t rise as fast as inflation. In equity markets, if companies can’t pass through costs fast enough, margins get squeezed.”

Sekera tips firms with wide moats, meaning they have durable competitive advantages, and pricing power to succeed. Coca-Cola (KO) and AB InBev (ABI) are examples of how strong brands allow firms to pass on costs to consumers, he says. February’s reporting season showed many Australian firms are keeping margins steady by passing on costs or cutting expenses elsewhere.

Banks and financials should benefit from improved margins in an environment where interest rates rise to tackle inflation, he says. Miners and basic materials producers are likely to gain from rising commodity prices. Real estate investment trusts are also an option where they have short-term leases that allow for regular price increases, he says.

“Hotel REITs are the ultimate in short-term leases. Most people’s stays are 1 to 3 nights,” says Sekera, who provided US-listed Park Hotel and Resorts (PK) as an example.

In a stagflationary environment, Miller suggests adjusting the 60/40 portfolio to reduce exposure to bond and equity market returns. A 50/30 split, with the remainder in assets like gold, broader commodity baskets or inflation-linked bonds is one option, he says.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend