For the last decade the biggest worry on economists’ minds has been deflation. Persistent low growth coupled with low interest rates have puzzled even the brightest minds in the field. We are not quite out of that supposed trap yet, though undeniably inflation has been moving upwards a bit over the last quarters.
As the labor market moves to and beyond full employment, according to economic orthodoxy we should now expect inflation to start rising. Combine that with tariffs which could raise the cost of imports and fiscal stimulus which likely comes at exactly the wrong point in the cycle, and you may see why some are worried.
What is stagflation?
In monetary policy, interest rates are lowered to stimulate economic growth. They are raised to battle inflation. That’s straightforward enough. Now let’s picture a situation of low economic growth and rising inflation. In a nutshell, that is stagflation.
The 1970s saw a famous period of rising oil prices combined with a recession, when interest rates went as high as 20%, the stock market lost as much as 40% and unemployment was raging. That followed a period of loose monetary policy aiming to generate economic growth and full employment. Sounds familiar? 2008 had a period where this happened that came dangerously close to it.
What assets to avoid during stagflation
During stagflation, interest rate sensitive assets and low yielding assets are best avoided. Interest rates are going up, and if you hold a 10 year US treasury bond with an assumed 8 year duration, you will lose roughly 8% for every 1% rise in rates (ignoring convexity).
You will also want to avoid REITs, while the return-above-inflation effect of stocks may only become apparent in the long run as companies may fare well with lower levels of inflation but may not be able to pass on higher levels of inflation to consumers that quickly.
What assets to invest in to protect against stagflation
Commodities are the classic inflation hedge, and prices of for instance oil and gold are expected to increase strongly during a stagflationary period. Inflation linked bonds will also hold their own, especially if inflation moves ahead of any changes to the central banks interest rates. Lastly, stocks of healthcare and consumer staples would be expected to fare better than the overall index as consumers can’t exactly choose not to eat or to pay for their medicines.
Portfolio construction: healthcare/staples, gold/oil and TIPS
- This portfolio consists of 5 parts of 20% each in healthcare, consumer staples, gold, oil and TIPS. Healthcare and consumer staples should provide stock market beta and yield in case the scenario does not play out, while each of the other three components have diversification benefits
- The 95% 1 year Value at Risk (expected max loss over 1 year with 95% confidence) is high at -19.2%.
|Energy||Vanguard Energy ETF||VDE||0.10%||20.0%|
|Gold||SPDR Gold Shares||GLD||0.40%||20.0%|
|Inflation linkers||iShares TIPS Bond ETF||TIP||0.20%||20.0%|
|Healthcare||iShares Global Healthcare ETF||IXJ||0.47%||20.0%|
|Consumer staples||Vanguard Consumer Staples ETF||VDC||0.10%||20.0%|
Risk, diversification and allocation
- Risk level: low to medium
- Diversification: high
- For risk and total return since initiation see Portfolios
- Probability of this theme playing out in the next 3-10 years: 10%-20%
Portfolio characteristics (full look-through, from USD perspective)
- Dividend yield: 1.9%
- Volatility: 7.6%
- 95% 1 year VaR: -19.2%
- Scenario 2008-2009: +2.1%
- Scenario 2010 onwards: +109%
- Scenario Interest rates +100bps: +0.1%
- Scenario 2008 Lehman crash: -13.1%