2022 Holiday Wrappings: Stagflation Special Report
All of us at Omega Point wish you and your loved ones a festive holiday season and a Happy New Year filled with excellent health, happiness, and success. We’re so grateful to have you alongside us as we continue to implement our shared vision of making it fast and easy for any investor to harness the world’s data in their decision-making process.
We plan to take the next two weeks off from publishing Factor Spotlight to celebrate the holidays with our families. Our next issue will arrive on Sunday, January 8, 2023.
In the meantime, we have prepared a special holiday edition of Factor Spotlight focusing on a growing hot topic for many investors - Stagflation. With consumer prices rising sharply and markets seemingly headed for another tumultuous year, we reviewed a wide array of recent articles and academic papers and are providing our readers with an overview of our initial findings. We hope you find it helpful, and as always, please reach out if you have any questions or want to learn more.
Omer and the Omega Point Team
What is Stagflation?
Stagflation is a combination of slowing economic growth and rising consumer prices. The leading cause of stagflation is generally believed to be a shift from a demand-driven to a supply-driven economy – more precisely, an economy where supply is restricted. The term stagflation was coined during the 1970s when the global economy experienced a sustained period of low employment and increasing price levels. Before the 1970s, it was generally believed that price levels were driven by an economy’s level of demand, which is a function of overall employment. The Phillips Curve predicts that increased employment leads to increased wages and, thus, increased demand for goods and services. The period of low growth and high prices observed in the 1970s was, therefore, a highly unexpected occurrence, which led to the consideration that the economy was, at that time, more impacted by supply than by demand.
Supply shocks are usually transitory as the law of supply and demand should drive suppliers to increase their output and meet the demand at a higher price –the increase in output ultimately leads to a decrease in price. In contrast, a stagflation period is characterized by a persistent supply-side shock –usually driven by macro events such as geopolitical instability. The macro nature of stagflation, together with the minimal number of stagflation events observed in the past, make it particularly difficult to model. Nevertheless, economic theory tells us to look at major sources of supply for a resolution.
Both asset owners and managers ultimately care about the consumption that can be bought from investment returns. If consumption is more expensive (i.e., the environment is inflationary), the dollars gained from investing lose part of their appeal in consumer goods and services. This is why measuring portfolio performance in terms of real returns is essential, especially during inflationary periods. The real return is defined as the nominal return – the return you normally expect using buy and sell prices – net of the inflation rate. The impact of netting inflation from returns could be significant and even push equity market risk premium, the outperformance investors expect above the risk free rate, into negative territory.
While supply sources should be our primary focus, governments' primary tool to mitigate the adverse effects of inflation on citizens is moving interest rates through central banks to adjust the cost of capital. Most developed countries' central banks have had a clear mandate to achieve specific inflation targets. In the past 30 years, a period of significant downward price pressures from globalization, central banks have generally achieved these targets, with inflation being stable at 2%. Central banks walk a fine line between 1) increasing rates, which generally raises unemployment, and 2) decreasing rates, which risks a rise in prices due to an overheating economy. We refer to a central bank aggressively increasing rates to control inflation as hawkish instead of dovish. A dovish central bank will put the economy first and hope for the best in consumer buying power. Central banks aim for a soft landing, where the economy slightly decelerates to keep consumer prices under control –while avoiding a recession. Of course, when supply-chain issues are deeply entrenched, central banks have no choice but to lean towards being hawkish, as evidenced by significant interest rate hikes observed in the past year.
Historical Look into Stagflation: 1970s
During the 1970s, supply impediments came from OPEC countries and the ensuing oil crisis. The consequences of oil price hikes crawled throughout the economy. Central banks were slow to react to increasing consumer prices and adopted a dovish stance early on. The depth of the problem called for an extremely steep increase in interest rates. Fed fund rates reached their highest point in modern history at around 20% in the early 1980s when inflation reached double-digit status. The dramatic increase in interest rates triggered a string of financial crises culminating in the market crash of 1987 –commonly known as Black Monday. Since then, central banks have clear mandates for maintaining price stability.
Risk of Stagflation in 2023
Today, we are suffering from the aftermath of the global COVID crisis and the war in Ukraine, which both profoundly disrupted global supply chains. The war in Ukraine led to energy shortfalls across Europe, which are now spilling into production/manufacturing issues, making it particularly susceptible to stagflation risk. Supply-side disturbances, together with US fiscal stimulus through the "American Rescue Plan" and delayed action by central banks in most developed economies to move to a hawkish monetary policy, have created a very fertile ground for stagflation to flourish.
Most developed countries injected significant stimulus packages into the economy during the pandemic and successfully avoided a recession. Now that the crisis has been averted, these packages must be unwound – e.g., by claiming deferred taxes. These actions put additional stress on the economy. Surprisingly, the economy shows extraordinary resilience in the current environment. We observe high employment rates despite rate hikes and the unwinding of fiscal and monetary stimuli. Consumer default rates remain under 2%, but personal savings rates have dropped to their lowest levels since 2005, which makes it all the more challenging to navigate during these times.
Most central banks have adopted a hawkish stance in line with their inflation targets, increasing the risk of derailing the economy. As a result, many experts expect economic growth to revert to levels observed in the early 2000s in the coming years. Suppose these fears are realized, and price levels continue to grow due to supply shortages. In that case, we will officially enter a stagflation environment.
Preparing your Portfolio
A legitimate question is how to prepare a portfolio for the dangerous waters ahead. This is challenging as stagflation events are rare, and there is no established rule book. Below we summarize a few approaches suggested by institutional asset managers and banks to protect portfolios.
One approach could be to add insurance to portfolios by buying assets that act as natural hedges against inflation, such as Treasury Inflation-Protected Securities [TIPS] and other real assets (eg. commodities). For example, Merk funds offer a Stagflation ETF composed of TIPS, gold, oil, and real estate. However, TIPS has dramatically fallen in value since the beginning of the year. This was due to a substantial yield rally negating the effect of the inflation adjustments embedded in this security. The issue here is that interest rates tend to covary with inflation, mitigating the impact of such hedges. Another concern is that inflation hedges perform strongly following surprises in inflation but may perform poorly in environments where heightened inflation levels linger. Finally, as opposed to the 1970s, commodity prices are not the main culprits – casting some doubts on the hedging effectiveness of commodity baskets to combat inflation risk.
From a sector/country tilt perspective, companies in less cyclical sectors may be better positioned to pass price increases, such as consumer staples, utilities, and healthcare. Even though more cyclical, the energy sector is an obvious candidate for hedging against rising energy prices. As mentioned above, Europe is in a particularly bad position to face stagflation. Therefore, tilting portfolios away from European countries could prove helpful.
A more data-driven framework to prepare for this type of sustained inflation environment is adopting a factor-aware stance for portfolio construction. For example, Baltussen et al. (2022) look at factor premia in the context of four inflation regimes going back to the 19th century. During high inflation periods, they find negative asset class premia but positivefactor premia in real terms. Moreover, the performance of most well-known equity factors such as Value, Momentum, Low Risk, and Quality “does not seem to depend much on the level of inflation”. This is better news for investors as such factors offer strong diversification potential during bad times.
Some factors or combinations presumably perform better than others during inflationary regimes. An analysis by MSCI uses data from December 1975 to October 2021 to understand how factors perform during rising inflation environments. In particular, they found that during periods of stagflation, Momentum, Quality, and Minimum Volatility were winners, whereas Value was a loser. In addition, Energy, Healthcare, Consumer Staples, and Utilities were winners on the industry side, while Information Technology, Materials, Financials, Industrials, Consumer Discretionary, and Communication Services were losers. These findings are illustrated in the chart below.
While looking at historical stagflation periods can help identify some empirical facts, we believe the current stagflation environment will unfold in a very different fashion than what we observed in the 1970s. For this reason, adopting a forward-looking approach rooted in economic analysis is equally important as analyzing historical Stagflationary periods. In a coming series of articles, we will leverage the Omega Point platform to demonstrate how investors can model their own views of how the environment will unfold, and tilt their portfolios accordingly.
We hope you enjoyed this initial treatment of Stagflation, and look forward to speaking about it with you more in the New Year.