Head of Saxo Strats
Summary: Our recent big macro call is that the global economy will enter a stagflation light period defined by higher than expected inflation and an uptick in the unemployment rate and lower real GDP growth as the combination of persistent supply shocks and bad economic policies will weigh on the economy. Based on limited historical data it seems that defensive sectors such as health care, consumer staples, utilities, and energy outperform all other sectors during periods of stagflation.
Our Chief Investment Officer Steen Jakobsen recently made a new call for the economy called stagflation light which is essentially a prediction that the economy will enter a period with higher inflation than what inflation swaps are pricing in combined with an uptick in unemployment and downturn in real GDP growth.
Stagflation is broadly defined as a period in which inflation remains high while the economy slips into a recession with increasing or high unemployment. The word is a melting of stagnation and inflation. The worst of two worlds.
Economists suggest there are two reasons behind stagflation. The first is a supply shock of a critical input factor for the economy causing high inflation and a recession at the same time. This phenomenon was the primary driver behind the stagflation during the 1970s due to energy shocks. The other potential driver of stagflation is the combination of failed industrial or growth policies combined with expanding fiscal deficits or the money supply at an above rate.
Stagflation is not been used many times in recent decades except for a brief period around 2011 when inflation accelerated while the EU was fighting an existential crisis with slowing growth and high unemployment rate. Last year in June the stagflation alarms were ringing again with the World Bank dedicating a press release to warn of stagflation risk in the wake of Russia’s invasion of Ukraine amplifying the already brewing global supply shock caused by the Covid pandemic. As inflation has eased with lower commodity prices and the economy has not slipped into a recession while labour markets have tightened even further the worries of stagflation has disappeared.
We acknowledge that we are out early with our stagflation light call, listen to our podcast from today for Steen’s more detailed explanation of our new call, but our reason is that we firmly believe that current policies around the green transformation, fragmenting supply chains, and shrinking pool of cheap labour will underpin inflation and MMT style policies will lower real GDP growth as debt and fiscal deficits will weigh on real GDP growth.
The first wave of stagflation was caused by the global supply shock due to the pandemic and large scale fiscal and monetary policies. With inflation easing most investors believe stagflation risks have disappeared. However, the real threat is the second wave of inflation which is not caused only by supply shocks but more structurally by bad growth policies and a changing geopolitical landscape. We do not believe in a stagflation like the 1970s, hence the light definition, but more like a long period of low growth combined with an uptick in unemployment rate and sustained inflation rate around 4% annualised.
Our chart above shows our stagnation indicator which is essentially the sum of the annual US inflation rate and US unemployment rate minus annualised real GDP growth. The grey area marks our definition of stagnation which is inflation rate above 3% and the overall indicator above 9%.
The issue at hand guiding investors on stagflation scenario as they relate to equity return is that sector classifications were not invented in the 1970s and equity indices have changed a lot since, so comparisons are almost impossible. Since 1989 we only observe 11 quarters of stagflation with the longest period being from Q3 1990 to Q3 1991 where inflation was above 4% with an unemployment rate around 7% while the economy slipped into a recession. Due to the small sampling size investors should be cautious about predictions of what things do well during stagflation. However, based on finding from the 1970s and our limited analysis based on quarterly figures since 1989 we so have some assumptions of what will do well.
Our first conclusion is that in periods with our definition of stagflation equities do bad. Based on data since Q4 1959, the S&P 500 returns 1.8% annualised excluding dividends during stagflation and 9.9% annualised during periods of no stagflation. In other words, stagflation is really bad for equity returns and it becomes really bad when inflation is subtracted.
Based on sector data and our small sample size since 1989 we see that during periods of stagflation sectors such as health care, consumer staples, utilities, and energy do well while sectors such as industrials, real estate, financials, and technology do poorly. In other words, it is precisely the four defensive GICS sectors that outperform during stagflation compared to the cyclical sectors (see MSCI Inc’s definition of cyclical and defensive sectors below).
Besides our limited analysis we know from Warren Buffett’s shareholder letters during the late 1970s that Berkshire Hathaway was increasingly looking towards businesses with a strong competitive advantage and pricing power over consumers and with high bargain power on wages against its employees. Warrant Buffett fell in love with Coca-Cola which he believed had all these characteristics to be a good investment during stagflation. So in the case stagflation bites, investors should focus on high ROIC companies, low share of employees in the production input, and a bargain power over its customers.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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