"Stagflation" may not mean what you think

Bottom line up top:

This is not your father’s stagflation (or anyone else’s, for that matter). Strictly speaking, stagflation occurs when deteriorating growth and rising unemployment are accompanied by hotter inflation — an unusual combination that hobbled the U.S. economy for a number of years in the 1970s. Despite headlines proclaiming or predicting the return of this unwelcome phenomenon, we don’t think ’70s-style stagflation is destined for a comeback any time soon.

Here’s what’s different this time. It’s true that growth is moderating from last year’s robust pace, amid high inflation and an oil price shock that for some may bring to mind the 1973 oil embargo and 1979 energy crisis. But the economy wasn’t just slowing from 1973 to 1975, it was in recession. Unemployment climbed as high as 9% in 1975 (versus 3.8% today). Moreover, in those days the U.S. was importing more than a third of its oil from OPEC and other producers, whereas today that figure is significantly lower, about 20%. Lastly, stagflation in the ’70s was precipitated in part by dubious policy decisions unique to the era, including wage and price freezes enacted in 1971.?

Investors resigned to the prospect of stagflation have choices. Over the past few weeks we’ve considered the portfolio implications of higher-for-longer energy prices and increased market volatility. Many of the investments we identified as potential outperformers in those environments could also prove resilient if, contrary to our outlook, stagflation were to materialize. Below we take a closer look at these ideas using historical analysis of asset class results from the 1970s.

Portfolio implications for a stagflation scenario

U.S. economic data supports still healthy (albeit modestly slower) growth. As we noted in our outlook heading into 2022, some deceleration was to be expected this year. One example shows up in the ISM manufacturing index. This cyclical indicator has come off its peak since May 2021 amid sharply higher inflation, but it remains firmly in expansion territory (Figure 1). At its current level, the index is consistent with U.S. GDP growth of about 4.1% — in stark contrast to its behavior during the stagflationary ’70s.

What actually happened in the 1970s. While stagflation is far from our base case, some investors are focused on the risk of a slow-growth, high inflation environment resembling the bad old days. Which asset classes proved resilient then? Commodities — particularly gold and oil — outperformed, based on annualized real returns, while stocks were the obvious underperformers (Figure 2). But to better understand investment performance during the stagflation era, it’s helpful to divide it into four “Acts.”

? “Act 1” (1973 – 1975) saw most of the commodity gains and equity losses, along with a real estate slowdown and a crash in the then-nascent U.S. REITs market.

“Act 2” followed from 1975 – 1976 with bull markets in equities and real estate, along with a severe drawdown in commodities and a cooling of inflationary pressures that is often forgotten.

? In “Act 3,” higher inflation returned with a vengeance, and new Fed chair Paul Volcker employed aggressive monetary tightening that ultimately led to the second recession of the decade.

? “Act 4” culminated with fading inflation and another painful stretch for commodities.?

Lessons for today? Recent asset class performance looks similar to that of the mid-to-late 1970s, when U.S. REITs and equities fared well after the initial commodity shock that started the decade. For today’s stagflation-wary investors, this suggests a portfolio with broadly diversified exposure to commodities, real assets and equities. At the same time, these investors may take comfort in knowing that today’s Fed is better equipped and more committed than its pre-Volcker counterparts to take an active role in combating higher inflation.?

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