A trader works on the floor at the New York Stock Exchange in Manhattan, New York City on Sept. 24.ANDREW KELLY/Reuters
In the stock market, as in geopolitics, the past has returned in uncomfortable ways.
Russia’s invasion of Ukraine, which revived 20th-century tensions, has also rekindled an economic relic of another era – stagflation.
The combination of a weakening economy and uncontrolled inflation is rare enough that few investors today have any experience with it. But the pros are suddenly on high alert.
More than 60 per cent of global fund managers surveyed by Bank of America are now forecasting stagflation – a near doubling from last month’s survey results.
For the first time in four decades, many investors are dusting off the stagflation playbook.
“Doing the same thing you’ve done for the last 15 or 20 years maybe isn’t going to work so well,” said Michael Greenberg, a portfolio manager at Franklin Templeton Investment Solutions.
Stagflation is by no means inevitable, Mr. Greenberg said. But the trends are all wrong. The war in Ukraine has worsened the global outlook on both the growth and inflation fronts. Energy and food costs are spiking around the world, while the Organization for Economic Co-operation and Development slashed its global growth forecasts this week.
GDP growth readings are still above trend. But if the global economy buckles, and inflation refuses to yield, it could bring an end to an era of stock market performance.
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For several years, particularly since the global financial crisis, markets have been sustained by ultralow interest rates and central bank support.
“Central banks have felt obliged to come to the rescue of the capital markets, because they’re more concerned about the employment side of the equation than the inflation side,” said David Stonehouse, head of North American and specialty investments at AGF Investments Inc.
It’s been a long time since policy makers have had to worry about inflation at all. “That gave them more latitude to respond to growth threats,” Mr. Stonehouse said.
When lockdowns began two years ago, the world’s central banks immediately cut policy rates to near-zero while flooding the financial system with trillions of dollars in stimulus. The pandemic-fuelled stock market crash lasted all of a month before the rebound started.
After keeping interest rates at emergency levels for two years, the U.S. Federal Reserve and the Bank of Canada are now officially in inflation-fighting mode. That may force them to sit out the next big stock market convulsion, instead sticking to a rate-hike program.
Rising rates are generally a negative for the stock market for a number of reasons. They increase borrowing costs, for starters. And they make future earnings worth less today, which is why the tech sector has performed so poorly this year.
Throw in the growth impact of stagflation and you get a hit to corporate earnings as well.
The first casualty could be the classic 60-40 mix of stocks and bonds, Mr. Stonehouse said. Rising interest rates and bond yields translate to lower bond prices. So a sizeable bond allocation may not provide much protection from the next stock selloff.
Stagflation could result in a “lost decade” for the 60-40 portfolio, Goldman Sachs strategists said in a note on Friday.
As an alternative to traditional fixed income securities, investors might instead look to inflation-protected bonds, and commodity-linked investments, Mr. Greenberg said.
Through the last major episode of stagflation, which accompanied the oil shocks of the 1970s, energy was the single best performing sector of the U.S. stock market, Stéfane Marion, chief economist and strategist at National Bank Financial, said in a recent note.
The other sectors that made gains were metals and mining, real estate and industrials. Overall, U.S. stock benchmarks suffered a deep sell-off, then traded sideways for the rest of the decade.
Canadian stocks, on the other hand, rose by about 50 per cent over the same timeframe. Then, as now, a heavy resource tilt seemed to blunt the impact of stagflation – either real or anticipated – on the Canadian stock market.
Look to unloved and low-valued markets and sectors to fare relatively well in a growth-challenged inflationary environment, like resources and infrastructure, Mr. Stonehouse said.
“Some of the champions of the last decade have had a really good run for a really long time with massive multiple expansion. They will probably face a lot more headwinds if we move to a stagflationary environment.”
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