If 2020 was a year for worrying about pandemic-induced economic collapse and the first half of 2021 was a time for worrying about post-pandemic inflation, for a growing number of traders the new cause of anxiety is a word that hasn’t been heard much since the 1970s: stagflation.
1. What is stagflation?
Stagflation is a portmanteau combining the words stagnation and inflation. It describes an economy with little to no growth and higher than normal inflation rates. Iain Macleod, a British politician, coined the term in 1965. Initially, many economists doubted stagflation was possible. Normally, unemployment and inflation move in opposite directions, since price levels are usually driven by an economy’s level of demand.
2. When has it happened?
The most famous episode came in the US during the 1970s. In 1971, President Richard Nixon reacted to balance-of-payments pressures by taking the US off the gold standard. The decision set the stage for a decline in the value of the dollar against other currencies throughout the decade, which added to inflationary pressures at home. Nixon tried imposing wage and price controls to combat inflation without much success.
Then in 1973, Arab members of Opec placed an oil embargo on nations they blamed for supporting Israel in the Yom Kippur War. In the US, the embargo led to skyrocketing oil prices. Businesses passed along that cost but also cut back on production, as what economists call a supply shock made goods more scarce, adding to a rise in inflation. At the same time, cutbacks in production led to increased unemployment. By 1975, the so-called Misery Index — the sum of inflation and the unemployment rate — reached 19.9% before peaking in 1980 at 22%.
3. Why has the term been revived?
It started with worries about inflation, which surged in many parts of the world beginning in the spring of 2021. The rollout of vaccines made coronavirus restrictions seem like a thing of the past. That created a strong rebound in consumer demand that was quickly met with shortages, given that supply chains were still reeling from the pandemic.
4. What’s changed?
The US Federal Reserve and most economists argued that cost pressures were likely to be transitory, a blip that would be sorted out as the recovery continued. But the emergence of the delta variant slowed economic growth and further squeezed supply chains for everything from semiconductors to cars. Labour shortages appeared in some industries, and food and fuel prices surged. Most ominously, energy shortages developed in Asia, Europe and elsewhere, driving up energy prices that did not seem likely to ease for months. That led even the optimists to worry that inflation may linger for longer than they originally thought.
5. Is the news all bad?
No. Economic growth remains robust in many parts of the world. That could mean that even if inflation proves stubborn, there is little reason to worry about the “stag” side of the equation. And most — but not all — optimists are sticking with their bet that inflation will be transitory. But worries are higher in the UK than elsewhere.
6. Why is that?
The UK is being hit harder by the energy squeeze than most of its neighbors, and faces something of a logistical crisis now that truck drivers from the European Union have lost their easy access to the UK labour market due to Brexit. Inflation fears are being stoked by the broader realisation that Brexit means that employers in need of workers face a harder time importing them.
7. What does that mean for markets?
A “fairly strong consensus” has developed among market professionals who believe that some kind of stagflation is more likely than not, according to a Deutsche Bank AG survey. Equity investors have reason to be concerned. Bouts of stagflation have historically been associated with declining profit margins, as companies face higher prices and dwindling sales. During the past 60 years, the benchmark S&P 500 index has returned 2.5% per quarter, but that quarterly return fell to –2.1% during stagflationary environments, worse than returns in environments characterised solely by weak growth or high inflation, according to Goldman Sachs. The setup has historically hit technology stocks hard, while stocks in the health care and energy sectors have generally outperformed. Goldman Sachs economists don’t have stagflation in their base case expectation, but the firm’s equity analysts told clients that stocks with strong pricing power are attractive if concerns continue to mount.
8. How about for policy makers?
It’s tricky, especially for central bankers. Usually they are aiming to boost growth or slow inflation rather than both at the same time. If the stagflationary forces remain, they will have to choose what to worry about most. For the moment, they are still hoping inflation will fade, allowing them to slowly unwind emergency stimulus settings. Some central banks, particularly those in Latin America, have already begun to raise interest rates. Fed policy makers are signaling that they will soon start slowing its asset-purchase program. But if stagflation takes hold, they may decide to move faster to reduce the inflationary threat even if that means curbing demand further. — Bloomberg Quicktake
