The global risk of stagflation is beginning to gain relevance in the financial markets and could probably take on even greater importance in the coming weeks depending on the interaction of some factors, including central banks and inflation. This scenario impacts all citizens and therefore, as investors, it is necessary to ensure that personal financial planning seeks to mitigate risks in this economic scenario, but at the same time seeks to maintain expectations of growth in wealth in the long term. But, what is stagflation and how to balance investments against it?
Stagflation is defined as a period in which there are mainly three factors: 1) The production of goods and services slows down, with a low or negative exchange rate (economic growth decreases); 2) There is an increase in unemployment rates, and 3) High growth in the price level (higher inflation). For example, in the United States there are two periods in which academics and professionals agree that they were stagflationary periods (between 1974-1976 and 1978-1982). During these periods, financial assets such as stocks and bonds tend to have high volatility and can lose value in absolute terms and/or relative to inflation.
Stagflation is a scenario that happens infrequently in the world’s economies and there are various factors that cause it, the main reasons being the combination of disruptions in supply and movements, generally upwards, of interest rates by central banks.
In the current scenario, multiple shocks to supply and impulses to demand have been observed in recent years, causing increases in inflation. The Covid-19 virus brought with it confinements, closures of seaports that are highly relevant for the transportation of goods, and interruptions in goods-producing plants, all of this reducing the supply of some goods around the world; even in China these disruptions continue.
The war between Ukraine and Russia has brought pressure on energy and food, since they are important producers of oil, gas, grains and fertilizers. Additionally, some commodities such as oil, gas, copper and nickel have been underinvested as a result of structural changes such as transfer to other sources of energy and materials. These disruptions have been accompanied by expansionary fiscal and monetary policies, especially in developed countries, which have brought acceleration in the demand of families.
It will be important to monitor the interaction of three factors at a global level to see if a stagflationary scenario consolidates. The first is that there are no major supply shocks and that productive chains begin to be reestablished.
Second, the behavior of wages adjusted for productivity, given that, if they increase without being productive, there is a risk of causing greater inflationary pressures; Accompanied by this, it is relevant to monitor the rates of participation in the labor market. And third, the speed with which central banks raise interest rates, whose dynamics are quite complex; Raising interest rates seeks to curb increases in inflation, but at the same time, it causes a deterioration in the growth of the economy, mainly given the high levels of global debt, but slowing down the rate of interest rate increases brings risks of accelerating more inflation due to a greater incentive to spending by companies and families.
Although it is not easy to protect investment portfolios in this scenario, since few financial assets perform well, there are actions that can be taken.
How defensive should an investor’s portfolio be? It depends not only on the economic cycle and asset valuation levels, but also on age, risk tolerance and goals. If the investor is very young, they may have greater risk or exposure to assets such as shares, but if they are close to retirement, they should be more protected from market fluctuations. In addition, the best course of action for an investor is to have a well-diversified portfolio with a multi-asset portfolio, in which there is exposure to defensive assets in this scenario, for example, merchandise or certain sectors such as health care, which tend to be be resilient by having a more inelastic demand and more limited valuations.
*The author is VP Portfolio Manager Asset Allocation of BBVA Asset Management.