Stagflation And Its Ramifications

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Stagflation warnings are back, and this has consequences for equity investment globally and locally, and investors must choose carefully among sectors and stocks.

-High inflation and slower growth now likely
-Recession possible, but jury is out
-Australia has certain advantages
-Which stocks to choose?

By Greg Peel

The prospect of “stagflation” reared its ugly head late last year when it was becoming increasingly apparent to global markets elevated levels of inflation were not as “transitory” as central banks were suggesting. The supply shocks caused by initial covid lockdowns were not receding as assumed, and instead were exacerbated by the new delta wave.

Yet still the likes of the Fed and RBA were insisting inflation would ease and emergency monetary policy – zero or near-zero cash rates and quantitative easing – would be required to support the economy for a long time yet. The first rate rises would not come until 2024, they assured.

The market was not so sure. The swift and sharp economic rebound in 2021 implied central banks had better start tapering QE and looking to raise rates sooner rather than later. Investment house T. Rowe Price said at the time:

“Although most central banks believe inflation will prove temporary, prices could remain elevated for an extended period – perhaps too long for them to hold onto their words and not take action.”

Prophetic. The above excerpt is from FNArena’s Equity Strategy: Into The Headwinds published in November. But despite concerns, economists were not of the view at the time stagflation was a risk – elevated inflation and slower economic growth, sure, these were “the headwinds”, but not a return to the 1970s.

In the interim, the world has seen a more contagious variant in the form of omicron, ongoing lockdowns in China due a stubborn zero-covid policy, and a war that supercharged energy and food inflation in particular.

It’s not surprising “stagflation” warnings are back – this time louder and clearer.

Recession?

The word stagflation is a mash of economic “stagnation” and price “inflation”. However it has no specific definition in economics.

We could take it as strictly meaning high inflation and an economic recession, or, as some economists are currently assuming, above average inflation coupled with below average GDP growth.

The jury is still out on whether the US economy will suffer a recession due to the Fed’s screaming policy about-face. Opinions vary from no recession to mild recession in 2023, to we’re already in one now. Even Fed chair Jerome Powell will not rule out a recession, while believing he can bring the US economy in for a “soft landing” – slower growth but not contraction.

The whole point of interest rate rises is to slow economic growth, thus easing inflation pressures. But given the Fed got it so wrong for so long until earlier this year, will it get it wrong again and raise rates so aggressively that recession is inevitable?

Bridgewater’s Ray Dalio explains:

“The facts are that: 1) prices rise when the amount of spending increases by more than the quantities of goods and services sold increase and 2) the way central banks fight inflation is by taking money and credit away from people and companies to reduce their spending.

“They also take buying power away by raising interest rates, which increases the amount of money that has to go toward paying interest and decreases the amount of money that goes toward spending. Raising interest rates also lowers spending because it lowers the value of investment assets because of the “present value effect” [lower future earnings in today’s dollars], which further lowers buying power.

“My main point is that while tightening reduces inflation because it results in people spending less, it doesn’t make things better because it takes buying power away. It just shifts some of the squeezing of people via inflation to squeezing them via giving them less buying power.

Dalio insists the cost of reducing inflation will be stagflation.

Macquarie’s Macro Strategy Team now expects most of the developed world (US, UK, Europe) to be in recession by 2023 as persistently high inflation forces interest rates into restrictive territory, ultimately resulting in slower growth and higher unemployment.

Central banks are behind the curve, the team suggests, and now need to do “whatever it takes” to get inflation down. This will likely require a mild recession with unemployment increasing by 2-3%. Macquarie expects July rate hikes of another 75 basis points from the Fed and 50 points from the RBA.

Australia is expected to avoid a recession for now, but growth will slow materially with the cash rate expected by Macquarie to peak at 3.1% by May 2023. The Strategy Team now expects national house prices to decline -15% peak to trough, having previously assumed -10%.

“Put more simply, by waiting too late to act, central banks have backed themselves into a corner, with a mild recession now needed to put the inflation genie back into the bottle. If central banks fail to do “whatever it takes”, we will be faced with a far worse outcome: 1970s style stagflation.”

There’s that word again.

Some History

Given there is no widely accepted definition of stagflation, identifying when it occurred is not straightforward. On deciding to frame stagflation as inflation above 3.5% while year-on-year GDP growth was negative, UBS found that Australia has only seen two such periods since 1960, the first being in 1974 and early 1975, with the second from late 1981 to mid-1983.

Note that the Arab oil shocks occurred in 1973 and 1979.

For equity investors, confining stagflation purely to economic recessions may be too limiting, UBS suggests. To expand the sample the strategists have relaxed the criteria to incorporate episodes when inflation was still above 3.5%, and growth sufficiently below trend, in this case below 1.5%. Using this more relaxed criteria allows for three additional periods to be incorporated into the study, mid-1977 to mid-1978 [ongoing rise in inflation from 1973], 1990 [Japanese property and stock market collapse], and mid-2000 to mid-2001 [US tech wreck].

In the two periods of genuine stagflation, equities fell by -48% over an 18-month window, UBS notes, with this slide being evenly split leading into and after the economy entered stagflation. In the “stagflation lite” episodes, equities fell by only -10% over the same window.

In both cases markets had bottomed six months after UBS deemed the economy’s stagflation experience to have begun.

This Time It’s Different

UBS is among a chorus of those who believe the situation we could face over coming years is unlikely to be anywhere near as extreme as the 1970s. The Australian economy suffered five quarters of negative real GDP growth in 1974 and 1975. Right now the UBS’ economists most bearish scenario does not even consider one quarter of negative growth to be likely.

Other key distinctions between now and the 1970's are the shift towards a services-based economy, and vastly improved energy efficiency. At the global level, totally energy consumed per unit of GDP is now around -70% below where it sat in the 1970s, UBS notes. Yet:

“Despite these differences being stark, the war in Ukraine has meant that a period of stagflation is not as far-fetched as we had previously thought.”

Longview Economics, in referring to the US economy, also dismisses a return to the seventies, citing three specific reasons.

Firstly, inflation in the early-mid 1970s was dominated by price controls, which distorted the usual relationship between inflation and money supply growth.

Secondly, unlike today, the Fed lacked the appetite to properly fight inflation, particularly in the late 1970s when unemployment was higher.

Note that central banks at the time had no price stability mandate, meaning they did not use monetary policy to tackle inflation. When US inflation began to surge from 1977 to 1979, to 12% compared with 6% in 1970, unemployment was around 6-7% and the cash rate was kept at 0.5% for most of the period.

Thirdly, a key driver of high inflation in the 1970s was the marked acceleration in the growth rate of the working-age population. At the time, a large generation of young people (baby boomers) entered the labour market and began to work. That resulted in a marked increase in money velocity (and therefore inflation), as those people began to earn, spend, and leverage up.

Today that effect is repeating itself, Longview notes. The millennials (born 1981-1995) are now the biggest cohort in US society, overtaking the baby boomers in 2019, and in the next 10-15 years they will drive a renewed uptrend in working age population growth. However, that uptrend has a much flatter gradient than it did in the 1970s and is likely to be much less inflationary.

The results of the 2021 census released this week showed millennials have also now overtaken baby boomers in Australia.

Longview further notes other factors, like the unionisation of the workforce, also contributed to higher inflation in the 1970s.

Australia suffered through a long period of union-led strikes in the 1970s. Just as well that’s not happening now.

Citi has also joined the discussion.

The most striking difference between the 1970s stagflation episode and today is that the inflation dynamic looks less entrenched, Citi suggests. By the early 1980s, US inflation had been trending up for fifteen years. Today’s inflation surge is a more recent phenomenon, which really didn’t manifest itself until the [northern] spring of 2021. The problem is one of fifteen months, rather than fifteen years.

In line with this, longer-term inflation expectations have remained well anchored, Citi notes.

In other words, while most see high inflation persisting through 2022, it is also expected to ease from today’s levels (May US headline CPI of 8.6%). Citi forecasts 5.7% by year-end, and a survey of the market has consensus at 2.9% in 2023.

Citi’s commodities team sees oil prices, a major CPI component, softening by year end, barring a major escalation in the war.

Feels Like

Economics is littered with “technical definitions”. A “bear market” is defined as a -20% correction. A “recession” is defined as two consecutive quarters of negative GDP growth.

In 2020, stock markets in Australia and the US fell over -30%. Now that must be a bear market. But it wasn’t, as the recovery was as swift as the fall. By comparison the S&P500 is down over -20% this year. That is a bear market, because it’s taken six months to get here.

The Australian market returned a peak in April and is now down -12%, so it can’t be a bear market. But why does it feel like one?

Stagflation, as noted, does not have a specific definition. But who cares? We know inflation is high and we’re pretty damned sure the economy is slowing – call it what you like. In Australia, CPI and GDP data are not released until a month/two months after the end of each quarter, by which time we’re all well versed in the price of petrol and lettuces, and have backed off our own spending and seen the same happen in our own businesses.

At least the US issues data monthly, even if initial GDP results are just estimates. But still, confirming high inflation and slower economic growth is by then more of a told-you-so moment rather than a wake-up call.

Equity and bond markets have already sharply corrected. Most see bond markets as having over-corrected, and believe in retreating they’re now about right in their assessment of where rate rises will reach. There nevertheless remains a consensus belief equity markets have yet to see a bottom, mostly because of a fear central banks will end up being too aggressive.

Central banks pumped too much money into the system from 2020 and stock markets became vastly overvalued. The risk is if central banks now pull too much money out of the system, too quickly, stock markets will become vastly not overvalued.

Stagflation, recession, whatever. There’s no point waiting around to find out. If it walks like a duck and talks like a duck, it’s a duck.

What To Do?

In terms of which stocks/sectors investors should consider to carry them through a period of stagflation/recession, or shouldn’t, analyst views are pretty uniform. And the concentration of such sectors differs according to geography.

Macquarie notes US GDP contracted in the March quarter which would make it a good recession candidate, but does not see contraction in the June quarter. Rather, Macquarie sees Fed rate hikes eventually taking their toll, sending the US into recession from the June quarter in 2023.

The view is little different for the eurozone, albeit a 2023 recession will be milder.

For China, Macquarie sees robust post-lockdown growth in the second half of 2022 thanks to government policy support. Further lockdowns nevertheless remain a risk to this view.

Macquarie sees Australia avoiding a recession for now, but growth will slow materially.

Citi recommends being overweight the US for its defensiveness and the UK and Australia for commodity exposure, and underweight Japan, Europe and Emerging Markets as they are too cyclical.

Note that exposure to commodities as an inflation hedge is a common recommendation among brokers, but this would be to some extent contingent upon China not going into any more widespread lockdowns.

Citi recommends Value over Growth at higher interest rates, and recommends being overweight in the defensives of telcos, utilities, consumer staple and healthcare, as well as energy and mining, and underweight financials, consumer discretionary and industrials as they are too cyclical, and technology as it is too exposed to higher rates.

UBS notes gold’s safe haven status comes to the fore during times of economic uncertainty. UBS warns that while energy exposure might be valuable in the short term, periods of high inflation and low growth ultimately lead to a contraction in energy demand.

Looking back at past stagflationary periods, UBS notes the TMT (telcos, media & technology) sector has been a top performer – telcos in particular given their ability to pass on costs.

What the broker doesn’t acknowledge is that both media and technology have significantly evolved since prior stagflationary periods – particularly the 1970s. Young readers might be surprised to learn we all got our news back then from newspapers and the TV/radio, and about the most “technological” household item was a colour TV.

Otherwise, staples and healthcare also performed well.

The worst performer at such times is Gaming & Leisure, but UBS is quick to note little market representation of this sector pre-1994.

Banks are among the worst performers given their exposure to economic cycles.

In terms of individual stocks, UBS notes prior outperformers in a “hard” stagflation environment (high inflation, negative growth) include businesses exposed to food production and retailing, which in today’s market would include the likes of GrainCorp ((GNC)), Rural Funds Group ((RFF)), Coles ((COL)) and Woolworths ((WOW)), and packager Amcor ((AMC)).

Infrastructure businesses also outperform, which implies APA Group ((APA)), Cleanaway Waste Management ((CWY)), Transurban ((TCLL)) and Telstra ((TLS)), among others. Gold stocks do well, and UBS likes Northern Star Resources ((NST)) and Gold Road Resources ((GOR)), and so do lottery businesses. The broker doesn’t highlight any, but presumably one can assume the likes of The Lottery Corp ((TLC)) and Jumbo Interactive ((JIN)).

Bus company Kelsian Group ((KLS)) is another suggestion from UBS, as well as IDP Education ((IEL)), suggesting strong demand as students choose to study ahead of better economic times, and finally InvoCare ((IVC)) is suggested as a “stone cold certainty” in a recession.

Note that for a stock to “outperform” does not necessarily imply share price upside, but equally less share price downside than the rest of the market.

In what UBS has described as “stagflation lite” (high inflation and weak, but still positive growth), the broker sees consumers “trading down” and thus benefiting the likes of Collins Foods ((CKF)) and Inghams Group ((ING)) – bit of a KFC connection there – and also less cyclical technology-skewed businesses such as Aristocrat Leisure ((ALL)), ASX ((ASX)), Computershare ((CPU)), JB Hi-Fi ((JBH)) and Xero ((XRO)).

Under sluggish conditions, leading and quality names should stand out above the pack, such as Commonwealth Bank ((CBA)) and Wesfarmers ((WES)), as should companies exposed to government infrastructure spending such as Downer EDI ((DOW)).

What To Avoid?

In a preface to which stocks to avoid in a stagflationary scenario, UBS notes it could reasonably just say “all of them”, but then there will be underperformers that are disproportionately hurt.

These would include stocks exposed to the residential property cycle, such as Adbri ((ABC)), CSR ((CSR)), Domain Group ((DHG)), REA Group ((REA)), Pexa Group ((PXA)), Mirvac ((MGR)) and Stockland ((SGP)), while weak property and jobs markets will weigh on Nine Entertainment ((NEC)), Seven West Media ((SWM)) and Seek ((SEK)).

If consumers do “trade down”, this could impact on Bega Cheese ((BGA)), Breville Group ((BRG)) Tassal Group ((TGR)), although Tassal is currently subject to a takeover bid, and Treasury Wine Estates ((TWE)). Likely to lose customers would be Adairs ((ADH)), Harvey Norman ((HVN)), Super Retail ((SUL)) and Temple & Webster ((TPW)).

Finally, UBS notes copper miners tend to be the counter to gold miners in times of stagflation, and OZ Minerals ((OZL)) and Sandfire Resources ((SFR)) may be hit hard. This could be complicated by the fact the by-product of copper mining is gold, and vice versa.

A fall in mineral investment would negatively impact on ALS Ltd ((ALQ)) and Monadelphous ((MND)).

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