Lower equity returns during stagflation Lower equity returns during stagflation Lower equity returns during stagflation

Lower equity returns during stagflation

Equities 5 minutes to read
PG
Peter Garnry

Head of Equity Strategy

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.


Key points in this equity note:

  • The Saxo Strats’ new call is stagflation light which is a period of higher than historical inflation combined with an uptick in the unemployment rate and persistently low real GDP growth.

  • Stagflation hit briefly the global economy in 2022 due to the global supply shock from the Covid pandemic, excessive fiscal and monetary policies, and finally the war in Ukraine.

  • Based on the limited history with stagflation our best guess is that defensive sectors such as health care, consumer staples, utilities, and energy will outperform all other sectors.

What is 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%.

Sectors and country indices during stagflation

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.

Source: MSCI
Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo or its affiliates.

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK Limited (“Saxo”) is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo holds a Type 1 Regulated Activity (Dealing in Securities); Type 2 Regulated Activity (Dealing in Futures Contract); Type 3 Regulated Activity (Leveraged Foreign Exchange Trading); Type 4 Regulated Activity (Advising on Securities) and Type 9 Regulated Activity (Asset Management) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products may result in your losses exceeding your initial deposits. Saxo does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo does not take into account an individual’s needs, objectives or financial situation. Please click here to view the relevant risk disclosure statements.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-hk/about-us/awards.

The information or the products and services referred to on this site may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and services offered on this website are not directed at, or intended for distribution to or use by, any person or entity residing in the United States and Japan. Please click here to view our full disclaimer.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc. Android is a trademark of Google Inc.