Feature Stories | Jun 30 2022
Stagflation warnings are back, and this has consequences for equity investment globally and locally, and investors must choose carefully among sectors and stocks.
-High inflation and slower growth now likely
-Recession possible, but jury is out
-Australia has certain advantages
-Which stocks to choose?
By Greg Peel
The prospect of “stagflation” reared its ugly head late last year when it was becoming increasingly apparent to global markets elevated levels of inflation were not as “transitory” as central banks were suggesting. The supply shocks caused by initial covid lockdowns were not receding as assumed, and instead were exacerbated by the new delta wave.
Yet still the likes of the Fed and RBA were insisting inflation would ease and emergency monetary policy – zero or near-zero cash rates and quantitative easing – would be required to support the economy for a long time yet. The first rate rises would not come until 2024, they assured.
The market was not so sure. The swift and sharp economic rebound in 2021 implied central banks had better start tapering QE and looking to raise rates sooner rather than later. Investment house T. Rowe Price said at the time:
“Although most central banks believe inflation will prove temporary, prices could remain elevated for an extended period – perhaps too long for them to hold onto their words and not take action.”
Prophetic. The above excerpt is from FNArena’s Equity Strategy: Into The Headwinds published in November. But despite concerns, economists were not of the view at the time stagflation was a risk – elevated inflation and slower economic growth, sure, these were “the headwinds”, but not a return to the 1970s.
In the interim, the world has seen a more contagious variant in the form of omicron, ongoing lockdowns in China due a stubborn zero-covid policy, and a war that supercharged energy and food inflation in particular.
It’s not surprising “stagflation” warnings are back – this time louder and clearer.
The word stagflation is a mash of economic “stagnation” and price “inflation”. However it has no specific definition in economics.
We could take it as strictly meaning high inflation and an economic recession, or, as some economists are currently assuming, above average inflation coupled with below average GDP growth.
The jury is still out on whether the US economy will suffer a recession due to the Fed’s screaming policy about-face. Opinions vary from no recession to mild recession in 2023, to we’re already in one now. Even Fed chair Jerome Powell will not rule out a recession, while believing he can bring the US economy in for a “soft landing” – slower growth but not contraction.
The whole point of interest rate rises is to slow economic growth, thus easing inflation pressures. But given the Fed got it so wrong for so long until earlier this year, will it get it wrong again and raise rates so aggressively that recession is inevitable?
Bridgewater’s Ray Dalio explains:
“The facts are that: 1) prices rise when the amount of spending increases by more than the quantities of goods and services sold increase and 2) the way central banks fight inflation is by taking money and credit away from people and companies to reduce their spending.
“They also take buying power away by raising interest rates, which increases the amount of money that has to go toward paying interest and decreases the amount of money that goes toward spending. Raising interest rates also lowers spending because it lowers the value of investment assets because of the “present value effect” [lower future earnings in today’s dollars], which further lowers buying power.
“My main point is that while tightening reduces inflation because it results in people spending less, it doesn’t make things better because it takes buying power away. It just shifts some of the squeezing of people via inflation to squeezing them via giving them less buying power.
Dalio insists the cost of reducing inflation will be stagflation.
Macquarie’s Macro Strategy Team now expects most of the developed world (US, UK, Europe) to be in recession by 2023 as persistently high inflation forces interest rates into restrictive territory, ultimately resulting in slower growth and higher unemployment.
Central banks are behind the curve, the team suggests, and now need to do “whatever it takes” to get inflation down. This will likely require a mild recession with unemployment increasing by 2-3%. Macquarie expects July rate hikes of another 75 basis points from the Fed and 50 points from the RBA.
Australia is expected to avoid a recession for now, but growth will slow materially with the cash rate expected by Macquarie to peak at 3.1% by May 2023. The Strategy Team now expects national house prices to decline -15% peak to trough, having previously assumed -10%.
“Put more simply, by waiting too late to act, central banks have backed themselves into a corner, with a mild recession now needed to put the inflation genie back into the bottle. If central banks fail to do “whatever it takes”, we will be faced with a far worse outcome: 1970s style stagflation.”
There’s that word again.
Given there is no widely accepted definition of stagflation, identifying when it occurred is not straightforward. On deciding to frame stagflation as inflation above 3.5% while year-on-year GDP growth was negative, UBS found that Australia has only seen two such periods since 1960, the first being in 1974 and early 1975, with the second from late 1981 to mid-1983.
Note that the Arab oil shocks occurred in 1973 and 1979.
For equity investors, confining stagflation purely to economic recessions may be too limiting, UBS suggests. To expand the sample the strategists have relaxed the criteria to incorporate episodes when inflation was still above 3.5%, and growth sufficiently below trend, in this case below 1.5%. Using this more relaxed criteria allows for three additional periods to be incorporated into the study, mid-1977 to mid-1978 [ongoing rise in inflation from 1973], 1990 [Japanese property and stock market collapse], and mid-2000 to mid-2001 [US tech wreck].
In the two periods of genuine stagflation, equities fell by -48% over an 18-month window, UBS notes, with this slide being evenly split leading into and after the economy entered stagflation. In the “stagflation lite” episodes, equities fell by only -10% over the same window.
In both cases markets had bottomed six months after UBS deemed the economy’s stagflation experience to have begun.