Investing in times of stagflation

Since the 1970s, growth in the global economy has not been as strong as it is this year. As economic growth slows and inflation rises, media speculation about stagflation is rife. The word stagflation is composed of stagnation and inflation. Stagflation poses a dilemma for central bankers because tackling inflation by definition means that economic growth comes under pressure and impulses to get the economy going lead to further rising inflation. The term stagflation further refers mainly to the doomsday scenario of the 1970s, with a stagnant economy on balance combined with high inflation. It was also the period when unemployment rose, in Western Europe, from 2 percent in 1966 to 10 percent in 1983. Now, on the contrary, there is a shortage of personnel and more vacancies are outstanding than ever. High inflation meant that interest rates were high in the 1970s, but they are still close to their historic lows today. In several ways, then, this period of stagflation is not the same as that in the 1970s. 

Stagflation dependent on the labor market

Stagflation is not good for the economy and certainly not for financial markets. In the 1970s, the stock market was in a state of doom and gloom; now it is setting one all-time-high after another all-time-high. Financial assets are highly valued, whereas in the 1970s the capital factor had a hard time. The power lay with the unions, who ensured that rising prices were linked to rising wages. Now the power of the unions is broken, but the pendulum between capital and labor is starting to swing in favor of the labor factor under pressure from governments, public opinion, and social media. It is therefore the labor market that will determine whether we will have a period of stagflation, characterized by high inflation and slow growth, or whether the new Keynesian policy will be reflected in less high inflation combined with clearly higher growth. The answer will be some time in coming, probably not until the second half of this decade. Until then, investors have to take a stance on what will happen in the long run, and they usually base that on what has happened now and in the recent past. Once inflation softens somewhat over the next six to 12 months, concerns about stagflation will fade into the background. Since the current high inflation is partly determined by base effects (the favorable basis of comparison relative to a year ago) and by deficits associated with the corona crisis, some high inflation may be seen as temporary. This does not invalidate the proposition that inflation could well fluctuate between 2 and 3 percent over the next decade, but a much higher level of inflation does not seem likely for the time being. 

Growth potential is underestimated

Post-corona, we are experiencing a revival of Keynesian policies. Demand failures are met by governments and central bankers in an unprecedented way. The government has become much larger post-corona, and monetary policy is being used to stimulate economic growth. We are therefore on the eve of an upward phase in the investment cycle. Indeed, corporate profits are at an all-time high but could be even higher if more can be delivered. This is a clear incentive for entrepreneurs to put down more capacity and invest in a production chain that is more geared to just-in-case than just-in-time. And it’s not just companies that are investing. Whereas after the Great Financial Crisis, governments in both the United States and Europe started to cut back, now the tap is going wide. In Europe, there is a major European recovery plan, and in the United States, the necessary investments in the field of infrastructure are following. Furthermore, a great deal of investment is also needed to deal with the climate crisis. Especially, the energy transition requires high investments. On balance, this will result in more economic growth rather than less economic growth. In addition to the start of a long-term investment cycle, there is also the doubling of the number of consumers in ten years, courtesy of Asia. Furthermore, we are at the end of the IT revolution, the moment where multiple technologies such as robotics, artificial intelligence, big data, cloud computing, virtual and augmented reality are providing numerous new applications that will also allow much of the boring and mind-numbing work to be automated or robotic. Today, many people still work in factories; in a few decades, much of that work will be done by robots. Many jobs in the service sector can also be automated. 

Higher inflation level

Current inflation is caused by supply-side problems, something about which concerns have increased in recent months, combined with a clear demand impulse thanks to money from governments and central bankers. Now, central bankers have a much smaller problem with inflation than in the past. Inflation is now seen as a means to solve the debt problem, and they do have other monetary policy priorities such as driving economic growth, accelerating the energy transition, and ensuring financial stability. Inflation is no longer a top priority. Inflation is allowed to rise now that average inflation is reckoned with, and compared to the past, central bankers are deliberately taking much longer to react to the higher level of inflation. Leading up to the Chinese New Year, when a large proportion of the Chinese return to their families in the countryside, some supply problems will be resolved. Probably some stuff will arrive too late for Christmas, but after that, the congestion problems in ports, among others, should gradually disappear. However, the reluctance of many years to invest in fossil fuels will lead to a substantially higher oil price, which will contribute to a slightly higher inflation level. On top of this, there are structural incentives such as an ageing population, deglobalization, the de facto tech monopolies, and the cost of sustainability. 

Conclusion

The probability of high economic growth with high inflation is much higher than the stagflation scenario where growth stagnates and inflation gets out of control. The 1970s were preceded by two decades where, although inflation was rising, there was also high economic growth. Given the high level of investment and the boost to consumption provided by a globally growing middle class, the current situation is more comparable to the Consumer Bull of the 1950s than to the stagnant 1970s. Stagflation is a low-probability scenario, but one with a high impact. In a stagflation scenario, commodities are the best performing asset class. In the 1970s, the price of gold rose from $35 to $800 per ounce; now bitcoins are the new gold until someone says the emperor has no clothes on. At a time when both inflation and growth are on the upswing, this is historically an excellent environment for equities. However, differences between companies will increase. Companies with strong pricing power and relatively few employees related to sales will then be preferred.