14/05/2022
Should we be worried about stagflation?
Stagflation is a term used to describe when economic output stagnates and inflation rises simultaneously. It's a nasty thing first observed in the 1960's. Stagflation defied conventional theory that told us prices rise in times of growth and fall in times of contraction. Real world experience tells us however, that theory and reality seldom precisely mirror each other, especially when you account for human behaviour or the systems we contrive where policy has the ability to adjust binary outcomes.
Stagflation is most commonly associated with the period of the oil crisis in the 1970's. This in itself can be broken down into two separate events in '73 and '79 both triggered by war leading to producers cutting oil supply. This echoes uncomfortably today, though whilst relevent, today's circumstances are not directly correlated to that time, making a direct comparison overly simplistic.
Conventionally, stagflation is accompanied by high unemployment. Today, we have close on practical full employment in the developed world. The consumer is for the most part in good shape. Household balance sheets are not overly leveraged and there has been a significant build up of savings over the COVID period. The US leads the developed world in terms of its reliance on consumption with close on 70% of its economy being reliant on the consumer. A healthy consumer generally means a healthy economy. Though the consumer is a fickle beast, confidence can feed as much back into behaviour as hard and fast theory. When so much of your economy is dependent on this you need to be as adapt at reading the tea leaves as doing the math.
Is stagflation a concern today? Not immediately at least. Whilst the labour market remains buoyant and household balance sheets strong, there is no need to become overly concerned. Though this is a precious thing. Central Bankers' primary tool to deal with inflation are interest rates and they are starting to pull the lever fairly hard. The median equivalised disposable income of a UK household is £29,900, that's what Joe Punter puts in his pocket after paying his taxes. From that, bills, mortgage, food and travel are paid as are holidays, clothing, pints, pocket money and so forth. Leave the science for a second and read the tea leaves. The price of everything Joe buys seems to be going up; his car is costing 1/3 more to fill then a year ago, food is more expensive and all the chatter on the radio is about cost of living increases. He's going to start feeling cautious. Now crunch in the effect of policy action. When the Central Bank raises rates to counteract inflation, Joe's mortgage goes up. The net result is he not only a little poorer but he also feels that way, so behaves differently, that's sentiment. Joe's an important bloke when so much of your economy is based on consumption. If he gives up support and you start inadvertently hammering him by increasing his mortgage rate you've got a problem. If we kill consumption in the current circumstances we kill the golden goose and stagflation may yet raise it's ugly head.
For investors today, the greater concerns should be positioning their portfolios to protect against inflation and, in light of the recent correction, to be cognisant of valuations. Some markets are begining to look inexpensive though others remain above their historical mean. The price you pay for assets, best measured by a cyclically adjusted price earnings ratio, is perhaps the greatest determinant of long term outcomes. That's boring but true... and has little to do with stagflation.
