FANews
FANews
RELATED CATEGORIES
Category Investments

Goldilocks and the stagflation threat…

17 November 2021 Gareth Stokes

The slowdown in fiscal and monetary stimulus in the West, coupled with elevated inflation on the back of supply-chain disruptions and spiralling energy costs, could see investors’ focus shift from cyclical companies towards defensive assets, including gold. “Although equities have soared amid the rebound in economic growth, a period of stagflation could favour more defensive assets such as gold,” writes Sean Markowicz, CFA: Strategist, Research and Analytics at Schroders, in recent commentary by the asset manager.

Stagflation, also referred to as ‘recession inflation’, is defined by Wikipedia.org as a situation in which the inflation rate is high, the economic growth rate slows and unemployment remains steadily high. The aforementioned scenario poses real challenges to central banks and economic policymakers because it becomes difficult to rein in inflation and create a business-friendly environment at the same time. Hiking interest rates is a traditional tool used to cool down inflation; but it works by putting the brakes on business activity and, has negative knock-on effects on economic growth and employment. 

Pinning hopes on transitory inflation

“The risk of stagflation presents a significant dilemma for economic policy makers, as actions intended to lower inflation may exacerbate the slow-down in economic activity,” said Scott Cooper, an Investment Professional at Marriott, in media commentary, issued early-November. “Over the past few months, economic data has suggested that the risk of stagflation is increasing … central banks hope, therefore, that inflation is transitory, so they do not have to react by raising interest rates”. 

Marriott is one among many global asset managers that believe US inflation will be transitory. They are, however, concerned that inflation will stay high for longer than was originally predicted by many commentators. “It is well known that supply chain bottlenecks, base effects, rising energy prices, shipping delays and other costs associated with the reopening of economies continue to have an impact on global inflation statistics,” writes Cooper. “However, we also need to recognise that some inflationary pressures are stickier than others, such as the shortage of long-distance truck drivers in the UK which is currently putting upward pressure on wages”. 

Four phases of the business cycle

Transitory or not, high inflation is likely to shift the business cycle from reflation to stagflation. “An unintended consequence of massive fiscal and monetary stimulus, and the rapid reopening of economies, [is that] global supply chains are unable to keep up with the surge in demand,” writes Cooper. “This is placing upward pressure on prices, and holding back the global economic recovery, just when pandemic relief measures are coming to an end”. Enter stagflation: high inflation rates coupled with lower economic growth. 

To get to grips with how stagflation affects investment returns requires a basic understanding of the four phases of the business cycle that arise from changes in economic output and inflation. Economists refer to these phases as goldilocks, disinflation, reflation and stagflation. PS: The goldilocks part of the cycle is an economist’s spin on the children’s book: Goldilocks and the three bears… It refers to periods when the market system is in an ideal state i.e. not too hot, not too cold, but just right! Investopedia offers this concise definition: “a goldilocks economy is just warm enough, offering steady economic growth to prevent a recession; however, growth is not so hot as to push it into an inflationary status”. It can, however, difficult to decide which of the four cycles an economy is in. 

“It can be tricky to evaluate asset class behaviour during each phase because markets are forward-looking, while conventional measures of economic growth such as GDP are published with a lag and may therefore inadequately capture pre-emptive asset flows,” said Markowicz. “Another challenge is that there is no universally accepted definition of what level of growth and inflation constitutes stagflation”. In broad terms, one can safely label a period during which month-on-month growth is slowing, and US inflation sits above 3%, as a shift from reflation to stagflation. 

Winners and losers in the stagflation ‘play’

Asset class winners and losers will fluctuate as we move from a reflation to stagflation cycle. “For example, the top performers during periods of stagflation have been gold, +22.1%; commodities, +15.0%; and real estate investment trusts (REITs), +6.5%. Equities have struggled, with -1.5%,” said Markowicz. These returns were revealed in a Datastream Refinitiv and Schroders analysis of the average real year-on-year total returns from US equities, US Treasuries, US T-bills, commodities, gold and REITs during each of the four business cycles, between 1973 and end-September 2021. US Equities shoot the lights out during the goldilocks and reflation cycles; but deliver negative returns under stagflation. In contrast, gold delivers 20%-plus returns under stagflation, but hovers near zero during each of the other cycles. 

Gold outperforms during stagflation because it enjoys status as a safe-haven asset that tends to appreciate in times of economic uncertainty. “Real interest rates also tend to decline in periods of stagflation as inflation expectations rise and growth expectations fall,” commented Markowicz. “Lower real rates reduce the opportunity cost of owning a zero-yielding asset such as gold, thereby boosting its appeal to investors”. Of course, gold seldom makes up a significant portion of a balanced portfolio, so asset managers will be looking to position clients’ assets in other potential sweet spots. Another area worth considering is commodities. 

According to Schroders, commodities tend to outperform during periods of rising inflation. Equities with commodities exposure will, therefore, perform well when inflation rises in a slow growth scenario, though returns will be weaker compared to periods of reflation. Similarly, REITs offer a partial inflation hedge via the pass-through of price increases in rental contracts and property prices. 

How can you clients navigate stagflation?

Marriott suggested that South African investors navigate stagflation risks by investing offshore. “Our key focus remains to identify companies that will prosper in the long-term but can effectively deal with the shorter-term inflationary pressures,” said Cooper. “We believe the companies we hold in our international equity portfolios are well-suited to current economic conditions due to our rigorous security filtering process, which ensures a well-diversified selection of stocks with pricing power and resilience”. The asset manager singled out Procter & Gamble for its excellent track record of growing dividends, even during market and economic turmoil. 

“Over the last six months, the reflation environment has favoured investing in risk assets such as equities and commodities, while gold has suffered,” said Markowicz. “However, if we are on the cusp of a period of stagflation, then a shift in performance leadership may be on the way; and that means that equity returns may become more muted, while gold may see increased demand as investors seek refuge in safe-haven assets”. He added that commodities and REITs were attractive alternatives. 

Writer’s thoughts:
I am always fascinated by pro-gold commentary, because it feels as if the precious metal plays less of a role in asset management nowadays. I would love to hear from financial advisers and / or asset managers about how gold plays a role in modern day portfolio construction, especially under the ‘rising star’ of Bitcoin and other altcoins? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za

Comment on this post

Name*
Email Address*
Comment
Security Check *
   
Quick Polls

QUESTION

South Africa’s economy is facing major policy and market challenges in 2025. As an adviser or broker, what concerns you the most?

ANSWER

Erosion of private property rights
Government interference in free trade
Inflation, administered prices
Weak growth, high debt
fanews magazine
FAnews February 2025 Get the latest issue of FAnews

This month's headlines

Unseen risks: insuring against the impact of AI gone wrong
Machine vs human: finding the balance
Is embedded insurance the end of traditional broker channels?
Client aspirations take centre stage as advisers rethink retirement planning
Maximise TFSA contributions before year-end
Subscribe now