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Investing During Stagflationary Periods

29 October 2020 By Mircea Vasiu

Equities are tumbling all over the world, led by the European and North American ones. 

In Europe, new lockdowns as a result of the second wave of the pandemic are responsible for equities’ underperformance. In the United States, the uncertainty generated by the U.S. elections in a few days coupled with the lack of a new round of stimulus had the same result – lower equity prices.

However, when investing, the time horizon expands to more than a few months or a year. Instead, we talk about decades of building a portfolio and managing it appropriately. Even active investing does not imply altering the portfolio every other day.

The coronavirus pandemic brought an economic recession all over the world. Together with it, the danger of stagflation – an economic phenomenon appearing in periods with high inflation and high unemployment.

What to Expect in Periods of Stagflation?

While high unemployment is already here, high inflation did not reach the developed world yet. In fact, central banks still fight the threat of deflation (e.g., the ECB). However, some central banks, like the Fed in the United States, did create the framework for addressing higher inflation, as it shifted its mandate towards average inflation targeting. Moreover, it announced that it is willing to let inflation overshoot the target. Therefore, we could easily see inflation much higher than 2% and still the Fed to do nothing about it.

In the case that high inflation happens at the same time with high unemployment, stagflation leads to interesting stock market sector performances. Three known periods in the past provide an example of what to expect should stagflation becomes a reality.

Discretionary stocks tend to outperform during stagflationary periods. These are cyclical stocks or companies that produce non-essential goods and services. Industrials, health care, and financial stocks follow. On the flip side, if we compare the average real return for the three periods in the image above, we see that utilities and telecom companies tend to underperform during stagflation.

However, all these are just statistics. The beauty of trading and investing is that no period is like the other, and the unknown creates opportunities all the time. The economic theories that exist help investors forming an educated guess about the best way to invest, depending on where the economy is on the business cycle. As such, investors can easily alter the portfolio in such a way to make the most of macroeconomic phenomena like stagflation.