💎 Wondering What’s ‘Stagflation’? (21 August 2022)

Lately, we have been hearing a lot of buzz around ‘stagflation’. Some believe we are approaching it, others think we are already living it.

Let’s try and understand a few important aspects of stagflation with the stories below.

The co-existence of ‘stagnant economy’ and ‘inflation’ leads to stagflation. And, it has been very rare in history. Why? Because generally, growth(and not a stagnant economy) leads to inflation

Always? No, we didn’t say that.

Growth leading to inflation

To fuel growth, central banks like RBI increase the money supply. It could be through printing more money or lending at lower interest rates. Now, consumers have enough money in their hands to spend. Consequently, businesses see better sales, more profits, and more jobs.

It becomes a circle of more jobs, higher salaries, and rising prices. The Central banks need to be vigilant and monitor the money supply to ensure that prices don’t go through the roof.

Price shocks leading to inflation

Say, your oil prices have risen, making other raw materials costly. Yes, this leads to inflation too. To manage inflation, Central banks reduce the money supply by increasing interest rates. Now, borrowing is costlier and that impacts the demand in a negative way.

Next, businesses take cues, slow down their manufacturing and cut jobs. So, there is inflation, job losses, and economic degrowth. Hello, stagflation!

Our take

It was only in the 1970s that stagflation was observed for the first time. Oil was the reason then and we have a similar oil price-induced inflation (not saying ‘stagflation’ yet!) today.

Many countries like China are already reducing their dependency on oil by getting into alternative energy sources. Currently, electric vehicles form more than 20% of China’s automobile sales. Well lessons for others to speed up and stay away from stagflation.

Let’s look at the US during the 1970s. The Vietnam war was going on and the US had already spent a lot on it. To make things worse, the energy crisis hit when OPEC decided to cut the supply of crude oil to the US due to geopolitical tensions.

By the mid-1970s, oil prices multiplied by 4 times from $3 per barrel to $12 per barrel. This resulted in inflation reaching 14% with 10% joblessness, and interest rates at 20% by the late 1970s.

Drawing similarities

The World Bank in its June'22 report mentioned some similarities between the 1970s and the current times: supply-side disturbances and prospects for weakening growth. It also lowered the world growth forecast to 2.9% from 4.1% anticipated earlier.

At present, the supply disruption caused by the pandemic and oil price shock due to the Ukraine-Russia conflict is leading to high inflation led primarily by high input prices.

But the differences

The global economy is much less energy-intensive than it used to be earlier. In 1973, the world used just under one barrel of oil to produce $1,000 of GDP based on 2015 prices. By 2019, the global economy needed just 0.43 barrels — a 56% decline.

Also, currently, people are better placed to absorb the high prices. Thanks to higher savings due to work from home, lockdowns, and the strong performance of equity markets over the past 2 years.

Our take

Well, no economic cycles are similar; each has different attributes. With the changing consumption patterns and technological developments, one can not draw exact parallels between what happened 50 years back and now.

But definitely, policymakers should take lessons from the past to see if wise decisions could be adopted with tweaks to suit the current context. And also, to ensure bad mistakes are not repeated to make matters worse.

When there’s the possibility of stagflation approaching, investors need to look for strategies that can weather both inflation and slow economic growth.

Emerging countries like India that have huge local demand might have a higher growth potential during such times than developed countries like the USA. Similarly, from a portfolio perspective, equities, debt, and commodities might behave differently.

Equity & debt

For equities, you need to monitor how companies are dealing with high input prices. To what extent are they able to pass on these prices to the consumers without risking to lose them? Say, essential consumer products would see a lesser impact than discretionary items.

Debt investments like FDs and bonds that give you fixed income, you need to be watchful if the fixed income is able to beat the rising inflation. For instance, inflation at 7% and FD at 6% are not helping you, right?

Commodities & Real estate

Think of the assets whose demand and/or prices will increase during stagflation. So, commodities like oil are required by businesses and see higher prices during such times. Next is real estate because here the prices might increase due to reasons like the rising population’s demand for residence.

And then you have gold that people resort to during economic uncertainty. During the 1970s stagflation, gold prices went up from $100 in 1976 to around $650 in 1980.

Our take

Replicating what exactly worked in the 1970s might not be the solution but diversification with the right strategies might work well. Also, before making an investment, analyze the near-term economic conditions, and what are policymakers up to.

When selecting investments, over-reliance on past returns might not be very prudent. Now the market conditions are different and strategies that worked well in the past 5 years might not now. Also, after making the investment, keep an eye on your portfolios closely in such uncertain scenarios.