Stagflation is not an everyday occurrence, the phenomena of stagflation in the 1970s that overtook the US was mainly caused by 3 factors, namely, the US dollar being decoupled from gold, the government’s price controls, and an oil embargo imposed by Arab states, which led to a sharp surge in international oil prices. It was not an exact parallel with the inflation we see today, which has been driven by the Covid-19 pandemic and ultra-loose monetary policies in the past two years. It is previously estimated that, with the virus outbreak subsiding, and global central banks kicking off their tapering cycles, inflation rates would gradually moderate to between 3% – 4% – even though it is far higher than the Fed’s 2% target, it did not appear to be the onset of stagflation.
But the vicissitudes of global geopolitics fell upon us: the Russia-Ukraine war erupted, which has led the prices of international crude oil, raw materials, and grain commodities to shoot up, fuelling the already persistent global inflation surge. Meanwhile, the US-Treasury yield curve has continued to flatten, pointing to an imminent economic recession that is looming closer with each passing day, and a heightened probability of stagflation. Having said that, whether stagflation will eventually become a reality hinges on factors from how long the Russia-Ukraine war will drag on, and when sanctions against Russia will be lifted. Nonetheless, investors should stay prepared for when stagflation does make its return.
One thing we should reiterate is that European countries and the US now face higher risks of stagflation, as most of them sit on the mid- and low- end of the global supply chain. But China, as a major contributor to global factories and supply chains, will bear less inflationary pressure and so a smaller risk of stagflation.
Characterized by the presence of both a recession and high inflation, stagflation certainly spawns concerns in many, as it significantly limits the policy space central banks have to manoeuvre – if it combats inflation by raising rates, it risks exacerbating the recession, but doing the opposite to stimulate the economy can end up intensifying inflation pressure.
Stagflation usually arises from a substantial increase in production costs. The main culprit of stagflation in the 1970s, for example, is the surge in oil prices. A rally in the prices of crude oil, the so-called “mother of all commodities”, typically spur valuations of other commodities. So in the event of stagflation, commodities will usually stand out from other asset classes.
Turning to equities, companies’ operating margins will likely come under meaningful pressure given that it is not always easy for most to pass on the increased costs to consumers within a short span of time. Compounded by discount rates being pushed up by interest rates hikes, the overall performance of equities will likely take a hit. However, we think companies with strong competitive advantages and pricing power will stay relatively untouched, and can even leverage this opportunity to beat their competitors and expand market share. So stock-picking is of even greater importance in a stagflationary environment.
Beneficiaries of rising commodity prices in the stock market include raw materials, energy, and soft commodities, such as financials, information technology and services, so their stock prices should hold up relatively well.
In terms of real estate, we think properties will likely outperform stocks for two reasons: The first is that landlords can usually raise rents as inflation rates go up because, for tenants, moving house is not just time-consuming and physically taxing, but also costly; the second is that the costs of renting out properties remain largely insulated from inflation, whereas companies will see their profits eaten away by higher costs as they may be hesitant to increase consumer prices in order to stay competitive.
Another point worth noting is the determination, or lack thereof, of governments to stamp out inflation with rate hikes in a stagflationary environment. In the 1970s, with the US government seemingly indecisive on the next course of action, the real interest rate dropped so low that there were occurrences of negative interest rates, meaning that taking out a mortgage would cost less than renting a flat, which was constructive to property prices.
According to historical data, the average annual growth rate of property prices in the US stood at 8.5% in the 13 years from 1969 to 1982 – while only a little over the inflation rate of 7.6% in the same period, it still held up better than that of equities at 5.1%.
Disclaimer
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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