English Markets

Stagflation (Q2 2022)

The environment has become unfavorable for virtually all investments, but the investors should be reluctant to make significant portfolio changes based on uncertain alpha research.

The spectre of stagflation

Few scenarios are as pernicious to private investors as stagflation. This toxic combination of economic stagnation with the risk of high unemployment and inflation reduces the standard of living of many citizens and the real returns to private investors.

Most market oracles were still arguing before the outbreak of war in Ukraine that economic growth remained intact.  But the sharp rise in commodity prices that followed the conflict has upset that picture, and forecasts for global growth are being revised downward and inflation upward.

Inflation has already exceeded the limits set by many central banks, which have very little room to maneuver. Ray Dalio, for example, told the Australian Financial Review that central banks around the world will probably have to start cutting interest rates again in order to rebuild their economies after a period of devastating stagflation. The decline in many financial assets may even force central banks to ease policy again (in the U.S., probably around the next presidential election in 2024).

Unlike the last decade with the equity boom (which could not last forever) and bonds as a stabilizer, the coming years could be more difficult. For the investor, it has become very complicated to know where to invest in an environment that has become unfavorable for virtually all investments. Thus, a historical review and the opinions of renowned investors may help us to see things more clearly.

Stagflation in the 1970s and today according to the World Bank

Stagflation is generally associated with the 1970s, when two separate oil shocks (an OPEC embargo in 1973 and a drop in production linked to the Iranian revolution in 1979) led to a sharp rise in prices and undermined consumption. Thus, today there are many similarities with the oil crisis of the 1970s, but also some fundamental differences

While the World Bank’s analyses are usually not very alarmist, its latest outlook on economic developments already speaks of global stagflation, the sharpest slowdown in growth in 80 years and no hope of improvement in the foreseeable future. The World Bank recognizes three parallels between today and the 1970s:

  • Supply shocks after a long period of very expansive monetary policy. These shortages were then, as now, primarily in energy and food.
  • The second parallel is the prospect of persistently low growth.
  • The third commonality, according to the World Bank, is the high vulnerability of emerging and developing countries due to high indebtedness and a strained financial situation.

The World Bank also cites some differences between the 1970s and today.

  • First, today’s fluctuations in energy and food prices are smaller than those of half a century ago, when oil prices quadrupled between 1973 and 1974 alone.  Today, the price of oil is “only” twice as high as it was in early 2021.
  • Second, central bank mandates are now more focused on the objective of price stability than they were then,
  • Finally, most industrialized countries can react more flexibly to crises;

Thus, while the situation is to be taken very seriously, many commentators do not see a repeat of the severity of the 1970s, but reasonable returns may be difficult to achieve. Thus, the hope is that a recession can be avoided and inflation contained by viewing current economic conditions (inflation and unemployment in particular) as more benign than during the stagflation years of the 1970s. 

It is therefore time to re-examine the strategic allocation of its assets, but without making major and precipitous changes. For the Bridgewater hedge fund, the focus should be on how to diversify a portfolio in a world where inflation is the dominant driver and stagflation is a very plausible outcome.  

Advice from Ray Dalio and Warren Buffett in times of stagflation

Global Macro investor Ray Dalio believes that we will most likely experience a period of stagflation and will need to build a balanced portfolio for this type of environment. Investors today are facing radically different circumstances than the favorable environment of the past decade for beta in general and equities in particular.   At the same time, for most investors, not holding risky assets is not an option. Ray Dalio, for example, told the Australian Financial Review that he avoids cash, fixed income and invests in inflation-protected assets such as power plant shares and commodities.

Speaking at Berkshire Hathaway’s annual shareholder meeting in 2022, Buffett reiterated his longstanding advice that is still valid in tough times: He said that unlike money, skills are inflation-proof.  For him the best investment is the development of oneself. In terms of financial assets, Buffett has pursued the same approach for decades and always favors strong companies that produce products that are in demand regardless of the performance of the dollar.

Stocks for the private investor in times of stagflation

The first recommendation for investors is not to panic and hastily sell positions. To create sensation and interest, the media often indulges in predictions of impending disaster that do not come true. Moreover, consumer balance sheets are strong, as a result of savings accumulated during the pandemic freezes. In addition, corporate profits are growing rapidly and have already surpassed pre-crisis levels. Thus, even in the case of stagflation, there is no real alternative to the tangible asset par excellence: equity. There are different types of stocks, which generally follow different rules:

  • Cyclical or defensive stocks: investors should ensure that they protect themselves against stagflation by investing in defensive stocks of companies with strong price power, as in times of inflation. These companies can pass on higher prices to their customers and thus adapt to the new situation. Cyclical stocks, on the other hand, should be treated with caution. In the event of stagflation, consumers will think twice before buying a product that is not necessarily necessary to satisfy their basic needs. 
  • Sector-based investments: Growth, industrial and technology stocks, especially related to automation, robotics or smart mobility were very expensive at the beginning of the year and have returned to more acceptable levels. For those investing in specific sectors (which is not the philosophy of this site except for geographic market and currency differentiation – see below), it is possible to add hedges in generally defensive sectors such as global health, energy and commodities that provide an effective hedge against the threat of a more protracted war in Ukraine or a sudden drop in energy supplies from Russia
  • Geographic Diversification: For investors strategically underexposed to Chinese or emerging equities, this may be a good time to diversify into a market that is oversold and priced right. Other geographies and currencies have also become more affordable, but such decisions depend on your individual situation and your current portfolio.

The passive approach remains valid in difficult environments

Investors can take action, even in a limited way, in the face of stagflation risk by gaining exposure to assets that might offer protection in this environment, without going into a buying and selling frenzy (see also our investment model for private investors).

When you look at what has happened in the economies and markets since the beginning of the year, risk premiums and discount rates have risen, hurting all assets. According to the hedge fund Bridgewater, this is the risk inherent in beta (market risk), and there is no way to diversify it. Alpha (which results from different bets in a market) can be extremely valuable, but it is difficult to generate and exploit on a large scale because it requires a unique view that is not already captured in the markets. This explains why about 90% of the risk in a typical institutional portfolio comes from strategic asset allocation and not from specific (asset) movements.  In addition, views on alpha are often wrong.

For example, Bridgewater Research concludes in its May 31, 2022 memo that it would be reluctant to make significant portfolio changes based on uncertain alpha research. If one of the world’s most renowned and sophisticated macro hedge funds adopts this caution and restraint, private investors should also consider a passive approach

In practice, if the worst-case scenarios do not materialize, the recent volatility offers an attractive entry point for gradual, targeted and measured investment in global equity markets. In the absence of an alternative for the private investor, it would also be an appropriate strategy, by default, in case of stagflation.

Building a Beta Portfolio in an Environment That Looks Difficult for Assets, 31.5.2022,
Die Weltbank warnt vor einer globalen Stagflation, 8.6.2022, Neue Zürcher Zeitung
Great pain’ will force central banks to cut rates, 8.6.2022,
Stagflationsangst: US-Anleger horten Bargeld-Bestände wie lange nicht mehr, 18.5.2022,,
We're going to have a period of stagflation, 4.4.2022,