In this timely analysis, Dan Kemp, Founder of Portfolio Thinking, explores the resurgence of stagflation fears. He also challenges investment managers to resist reactive positioning, highlighting the importance of valuation, diversification, and a disciplined decision-making in the uncertain macro environment we face right now.
Stagflation is both a blot on the English language and an unusually challenging economic environment for consumers, businesses, and investors. It is therefore unsurprising that the growing risk of stagflation causes fear among participants in capital markets.
This fear is evident in the way investors responded to the spike in energy prices that accompanied the war in the Middle East and the weak economic growth revealed in the most recent estimate of US GDP. However, this visceral response is worth examining carefully. In markets, the emotions that feel most urgent are often the least reliable guides to action. To navigate these challenges successfully, we must learn the lessons of history.
We Have Been Here Before. The Map Exists.
The 1970s did not announce themselves as a decade of stagflation. They arrived through a sequence of individually explicable shocks: the breakdown of the Bretton Woods currency system, an oil embargo, wage price spirals, and a central bank that was too slow and then too erratic in its response. In retrospect, the narrative arc seems clear. At the time, it was bewildering.
The parallel today is instructive. The structural ingredients of a stagflationary environment are all present in some form. The energy shock is acute and geopolitical in origin. Core inflation, even before the most recent oil move, was proving stickier than consensus expected. Furthermore, central banks face a genuine dilemma: hold rates into a weakening economy to contain inflation or cut rates and risk entrenching inflationary expectations.
The similarities with that earlier period are beguiling, creating a plausible narrative about the future around which we can build our investment positions. However, it is important to recognise that the ingredients of stagflation are well known and consequently less likely to lead to the exact same conditions that plagued that earlier decade. Simply having similar starting conditions does not guarantee the same outcomes.
The key risk we face now is that we become overconfident about the likelihood of a single plausible outcome, rather than considering a range of possible paths forward and assessing the impact of each path on our clients’ portfolios.
What the Valuation Anchor Reveals
The discipline of valuation is particularly valuable in an environment where narratives are moving faster than fundamentals. Before the most recent energy shock, many investors observed that the valuations of the world’s most prominent equity markets were pricing in an optimistic sequence of events: resilient corporate earnings, contained inflation, and an orderly return to rate cutting. That pricing left little margin of safety for disappointment.
As concerns about stagflation mount, expensive growth focused companies that derive their value from earnings far in the future are particularly vulnerable to an environment where both the discount rate and the earnings growth assumption are under simultaneous pressure.
While this scenario is challenging for investors whose portfolios are dominated by US technology giants, this environment may provide opportunities to acquire outstanding businesses at attractive prices elsewhere.
Three Priorities for Stewardship
When navigating challenging conditions, it is important to prioritise research over reaction. This is especially vital when working with individual investors, who often feel the strongest impetus to fight or flee, risking being whipsawed by changing market conditions. To combat this behavioural trap, wealth managers should focus on three priorities:
- Clarify the Investment Horizon: Before making any changes, confirm the time horizon of each client. While we know that clients who panic and sell today to avoid uncertainty tend to lock in real losses that inflict permanent financial harm, following the recent success of ‘buying the dip’ can also lead to further losses if the downturn lasts longer than previous shallow corrections. Clients investing today need to have sufficient patience to hold their investments through deeper challenges.
- Audit for Genuine Diversification: One of the more uncomfortable reminders of the current environment is that the traditional diversification benefits of long duration government bonds are lessened, or even negated, during periods of stagflation. Consequently, genuine diversification requires assets whose return drivers are structurally different from both equities and nominal bonds.
- Use Valuation over Narrative: As every consumer knows, a discount does not mean that a product offers good value. The same is true in investing. An asset that was significantly overpriced may have to fall a long way before it offers a genuine margin of safety. The emergence of fundamental fair value should be the key trigger for making changes, rather than our amateur assessment of whether the current geopolitical situation will escalate or resolve.
It is not possible to know whether the current energy shock will prove transitory or structural. However, we do know that the best investments are made when the future appears bleakest. While the spectre of stagflation is uppermost in the minds of investors now, we know that it will be replaced by some other ghost, either benign or terrifying, in the future.
Our role is to help investors move through these apparitions, not by predicting the path ahead, but by ensuring that each footstep is securely placed on the path towards their goals.
Markets on edge? Why diversification is your first line of defence.
Get expert guidance on MPS construction, asset allocation, and portfolio design by downloading IFA Magazine’s latest MPS Insights Publication and earn CPD HERE.
