There are some reports around at the moment concerning the emergence of future stagflation in developed economies and what this could mean for equity markets. It is worthy of consideration because there are three economic fundamentals to stagflation and two of them are very much in evidence and arguably all three are present in certain economies and industrial sectors.
The technical definition of stagflation is when a country experiences slow economic growth with relatively high unemployment – so called economic stagnation – accompanied by rising prices or inflation. The reason why it is so defined, like an economic cocktail, is because it offers conflicting outcomes from the policy levers that are available to the authorities. Most policies designed to lower inflation tend to slow the economy, namely higher interest rates and this usually increases unemployment. Similarly, policies designed to increase employment tend to raise inflation and therein lies the policy conundrum.
The most notable textbook example in history is that which occurred in the 1970s when oil prices spiralled due to the OPEC oil embargo. This was a response to US support of Israel during the Yom Kippur war. High oil prices increased global inflation dramatically, which led to economic hardship and increased unemployment. In the UK, this was a precursor to industrial action, as wage freezes were introduced across nationalised industries such as the coal industry. The imposition of a 3 day week followed to conserve electricity as strikes erupted, by which time the oil crisis ended. However, it was a period of economic turmoil, policy muddle and an environment of rising prices, rising unemployment and economic recession. In such cases, a dilemma arises for policymakers: whilst the inflation problem suggests that the Central Bank should be raising interest rates, the weak economy contradicts this, suggesting that they should be cut. Meanwhile, economic growth is falling but the Government cannot afford fiscal stimulus because debt levels won’t allow it. A nightmare.
If we apply this historic example to western economies today, there could be some degree of overlap ahead despite the current economic environment appearing settled and resilient. The US and UK economies are currently in reasonable shape with virtually full employment, controlled inflation and weak but acceptable economic growth, so no apparent stagflation worries there. However, inflation is on the rise for differing reasons in both economies and neither case is due to an excess of demand.
In the US, CPI statistics are picking up, mainly due to the declining oil price dropping out of the figures, but they are also registering the end of the export of deflation from the East as the wave of import substitution has come to an end. President Trump has so far stepped back from imposing any kind of trade protectionist policy, but he also hasn’t yet tried, having realised this will win him few friends in the world. His differing tune in the Middle East this weekend showed just how much he has had to temper his rhetoric from what he said as Candidate Trump. However, he has made promises to the rust belt on unemployment, that he will return their jobs from China and they will be getting impatient before long. Changing stance on international policy doesn’t lose votes, whereas failing unemployed voters from the mid-west will cost him his second term. If and when we see the imposition of trade protectionist policy, economists agree this will result in inflation via the imposition of tariffs and this would set the US economy up for stagflation. The inevitable price rises would lead to falls in disposable spending power and a slowdown in economic growth and an increase in unemployment – the exact economic cocktail of stagflation.
In the UK, we are currently seeing inflation rise, this being the key aftershock of the Brexit Sterling earthquake. Economically, the UK economy has been relatively unscathed following the vote, but CPI is rising partly for the same reasons as the US, whilst import costs rise following Sterling’s fall. Although exports have received a welcome competitive boost and overseas tourism is strong, the UK economy runs a trade deficit as we have a service economy with import costs from the EU rising significantly so far this year. Whilst no-one is particularly worried about inflation getting out of control because it is not being caused by excessive demand and wage growth, the reality is that, again, similar to the possible US outlook, disposable spending power is falling as prices rise and especially as wage growth is below the CPI. This is likely to slow economic growth and increase unemployment whilst inflation rises, underpinned by the weak pound as we negotiate Brexit. This is stagflation.
In the Eurozone, with the exception of Germany, much of the continent has been experiencing high unemployment and very low growth, if not recessionary conditions in some of the indebted peripheral countries. Inflation has been relatively benign but there has been a general move over the last six months to a range between 2 to 3 per cent for similar reasons as in the US. Quantitative Easing is still in place but arguably this should be stopped as it is only really there as an insurance moral hazard to stabilise the euro and consumer confidence against political shocks. At some point, the Draghi put option has to be taken away and the Eurozone has to stand on its own feet. So, although stagflation is not in place in the Eurozone, if inflation rises much more, this will present the exact same policy dilemma whereby prices are rising beyond an acceptable target level but the authorities cannot raise interest rates to combat it because economic growth is not strong enough. Hence the reason why fiscal stimulus is the latest popular political economic weapon. The hope is that this will keep economic growth propped up, but it has to be funded by government debt, is entirely artificial and does not create longer term economic prosperity. Once the bridge, road, railway or airport is built, the jobs go, the productive output stops, but the debt remains.
So, if you buy the argument that we are encountering a period of rising inflation, slowing economic growth and rising unemployment, what does this mean for the markets? Well, as ever, it is not clear cut. On the one hand, a UK investor will need real assets to combat inflation which implies equities and property. However, if consumer spending is under pressure then UK domestic equities exposed to the consumer are probably not a great idea, with the exception of hotels and leisure for tourist spending. Overseas equities are potentially far more attractive with a caveat for the US and Europe vis-à-vis their valuations, the latter looking better value.
Fixed Interest continues to look unattractive as inflation and interest rates rise, whilst Commercial Property and Infrastructure look very attractive for their less volatile real returns producing sources of attractive income. However, they are not cheap as shown by the premiums within the investment trust sector. But if the net asset values continue to rise with government fiscal spending, this premium may be worth paying for.
There is no historical economic precedent to call upon for clues as to what happens next to the global economy after ten years of Quantitative Easing following a banking crisis. We are clearly through the worst of the credit crunch aftermath, but as we wind down Quantitative Easing and inflationary pressures start to build, a dose of stagflation may be the likely outcome. This doesn’t have to be that bad as the potential dynamics are nowhere as extreme as those that prevailed in the 1970s. But then again, there is a lot more debt around, both personal and government. Small reductions in consumer spending power and small interest rate rises could have a profound effect on consumer behaviour and economic growth. This is probably one of the biggest unknowns of today and the next few years as we start to reverse the post-credit crunch economic stimulus.
At least we now know that the QE nuclear option is there to save the day should the wheels come off – let’s hope it doesn’t become an economic Molotov cocktail.
Guy Stephens, technical investment director at Rowan Dartington