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  • Writer's pictureEng Guan

Stagflation - What You Should Know

Stagflation is a word that strikes fear for those who know what it is. And for those who don't, you will learn it the hard way when it comes. While it remains to be seen whether we will be moving into an extended stagflationary period, news about it is everywhere today. Even Ray Dalio, the founder of Bridgewater Associates, one of the largest hedge funds in the world, tells the world to brace for tough times ahead. So what is stagflation?

What is Stagflation?

Growth and inflation tend to come hand in hand. In order to grow, we accept a certain level of inflation. As long as the former more than offsets the impact of the latter, we are in good shape. But when inflation gets out of hand and our economy stagnates or declines at the same time, then we are in a particularly messed up situation. To put it simply, if that happens, we are in the worst of both worlds. And hence the term - Stagflation - a stagnant economy with high inflation.

Stagflation is a big headache for central bankers

Stagflation is one of the worst nightmares for central bankers. Why? Because they don't have the tools to prop up the economy and fight inflation at the same time. To tackle inflation, they have to tighten the monetary policy and raise interest rates. But that is likely to sink the economy further. On the other hand, if they want to stimulate growth, they need to ease the policy and lower rates. But that means inflation may spiral even higher. So they are certainly not in an enviable position. It becomes a choice of prioritizing one risk over the other. But that said, central bankers, often play a key role in creating these messes. Because excessive money printing is one of the key ingredients for stagflation.

The 1970s Stagflation

The world is no stranger to stagflation. Because we lived through an episode in the 1970s. This is a period plagued by many challenges. A slowing economy with rising unemployment. Surging commodity prices, in particular, crude oil which almost quadrupled due to an OPEC embargo. Strong worker unions pushing for pay increments to manage rising prices (real wages adjusted for inflation were not growing then). A US Federal Reserve that maintained an easy money policy and turned a blind eye to soaring inflation early on. When you mix all these in, it becomes a potent recipe for the perfect storm. There is more than one recession during this period. The annual inflation rate reached a high of 13.5% in 1980 and Fed raised the Fed Funds rate to 20%. That sets the stage for a downturn in the early 1980s before inflation abates.

Annual GDP Growth, Inflation & Unemployment Rate in 1970s
Annual GDP Growth, Inflation & Unemployment Rate in the 1970s

How Did Stocks and Bonds Fare During The 1970s Stagflation?

As investors, our main concern is how stagflation will affect our investments. And for the majority of us, it is quite unlikely we invested through the 1970s. So there are not that many out there with firsthand experiences. But that said, we can always fall back on historical data to tell us what happened and validate our thinking.

Now, we expect high inflation to adversely impact the market. Because it erodes the value of all future cash flows for both stocks and bonds. It also forces central banks to raise interest rates which further dampens their prospects.

To assess their performance, we look at the period from 1969 to 1982. 1969 is the year when yearly inflation starts ramping above 5%. And 1982 is the year that marks the end of the last recession triggered during this stagflationary period. So, let's see how our two most popular traditional asset classes - stocks and bonds fare during this challenging period. For stocks, we will use S&P 500, and for bonds, we will use the 10Y Treasury Note.

Both stocks and bonds delivered positive nominal returns

Contrary to what some of you might think, both stocks and bonds still delivered positive returns from 1969 to 1982. But note this is before adjusting for inflation.

Non-Inflation Adjusted Performance of S&P 500 and 10Y Note (1969-1982)
NAV of S&P 500 and 10Y Note (1969-1982)
Performance Summary of S&P 500 and 10Y Note (1969 - 1982)
Performance Summary of S&P 500 and 10Y Note (1969 - 1982)
Yearly Performance of S&P 500 & 10Y Note (1968-1982)
Yearly Return of S&P 500 & 10Y Note (1969-1982)

The S&P 500 (including estimated dividends) returned 6.7% per year and the 10Y Treasury Note 6.9% (source: On the surface, it doesn't look that bad. The 10Y Note, in particular, did surprisingly well, considering sky-high inflation, and with Fed Funds Rate raised to a peak of 20% during this time. And while the S&P 500 was down in five out of the thirteen years, the 10Y Note was only down for two years. But if you look at maximum loss, the 10Y note did experience a hit of -14.9% which is significant by historical standards.

Both stocks and bonds go into negative territory if adjusted for inflation

However, things are not as rosy if we adjust their performance for inflation. The average yearly inflation from 1969 to 1982 is about 7.6%. That means what you make from investing in S&P 500 and the 10Y Note will not be sufficient to make up for the price increases around you. So even though you made money, you are actually worse off or technically poorer than before 1969.

Inflation Adjusted Performance of S&P 500 & 10Y Note (1969-1982)
Inflation-Adjusted* NAV of S&P 500 & 10Y Note (1969-1982)
Inflation-Adjusted Performance Summary of S&P 500 & 10Y Note (1969-1982)
Inflation-Adjusted* Performance Summary of S&P 500 & 10Y Note (1969-1982)
Inflation-Adjusted Yearly Return of S&P 500 & 10Y Note (1969-1982)
Inflation-Adjusted Yearly Return of S&P 500 & 10Y Note (1969-1982)

CAGR reduces to about -1% for both and the max losses increase near to 50% when adjusted for inflation. Now, out of the thirteen years, S&P 500 is down in seven of those years. The 10Y Note, on the other hand, registers a big difference. It is now down in ten out of those thirteen years. The result is not surprising as the 10Y Note delivers a lower albeit more stable yearly return. So when inflation is high in those years, they will lose out.

* Estimated by adjusting the nominal returns using the yearly inflation rate (source: FRED)

Stocks and bonds still beat cash

Despite the harsh market climate in the 1970s, investing in stocks and bonds still beats holding cash. At least, they prevented you from losing the full extent of your purchasing power. If you just held on to cash, your money would depreciate by 7.6% on average each year. That is one reason why you find market quotes such as this "Cash is Trash".

What are some assets that can fare better during stagflation?

These are either assets that drive inflation or respond to inflation. So we would reasonably expect commodities such as crude oil, gas, wheat, iron, and so on to perform relatively better. Since they are among the key drivers of inflation. But this asset class tends to be volatile and seasonal in nature.

TIPS (Treasury Inflation-Protected Securities) is another one with the potential to thrive under heightened inflation. They are essentially Treasury securities with a built-in inflation protection mechanism. When inflation rises, their principal value increases. This, however, can be negated if interest rates are also rising fast at the same time. Because higher interest rates push down their prices. So how it performs will hinge also on how fast and how much the central bank raises interest rates to fight inflation. But that said, it can perform better than nominal bonds such as the 10Y Treasury Note in such an environment.

Gold is another security worth mentioning here. Technically, Gold is considered a physical commodity. But because of its history and use in the global monetary system back in the past, it has a special place within the market. Even though the world has long dissociated from the Gold standard where currency used to be backed by physical gold, it is still very much treated as a safe haven and hedge against inflation. Yes, it is not a perfect hedge because there are other factors that work against Gold. But over the long run, it seems to do its job.

As the historical price data for Gold is more readily available, let us take a look at how it performed in the 1970s.

Gold delivered solid nominal returns in the 1970s

In nominal terms, i.e. without adjusting for inflation, Gold delivered a CAGR of 18.4% from 1969 to 1982. This is well above the average inflation rate of 7.6% then. But the ride is volatile with big swings.

Performance of Gold Against S&P 500 & 10Y Note (1969-1982)
NAV of Gold (1969-1982)
Performance Summary of Gold (1969-1982)
Performance Summary of Gold (1969-1982)
Yearly Return of Gold (1969-1982)
Yearly Return of Gold (1969-1982)
Gold achieved good real returns above inflation in the 1970s

Even after adjusting for inflation, Gold still achieves a decent real CAGR of 9.8% over the period.

Inflation-Adjusted NAV for Gold (1969-182)
Inflation-Adjusted NAV of Gold (1969-182)
Inflation-Adjusted Performance Summary of Gold (1969-1982)
Inflation-Adjusted Performance Summary of Gold (1969-1982)
Inflation-Adjusted Yearly Return of Gold (1969-1982)
Inflation-Adjusted Yearly Return of Gold (1969-1982)

Will what worked in the 1970s still work today?

I am sure you heard this quote before "History is not a guarantee of the future". While this statement is often overused to dismiss historical findings, it is valid when viewed from an objective perspective. In fact, it is just common sense. If history holds all the answers to everything in the future, then financial markets wouldn't be what it is today. But having said that, we don't look back to history for guarantees. Rather we study them to learn and find given what we know, the best way forward. But whatever course of action we decide to take, many questions remain.

Will Gold still be as effective given that we have completely severed the Gold standard since the 1970s? Will bonds suffer even more than during the 1970s given that we are now in such a low-interest-rate environment? How long can the economy hold as Fed increases its rates? Will a recession be triggered and if it comes, will it be enough to stem the rise of inflation? Will the current demand-supply imbalance resolves itself as the world normalizes and more people rejoin the workforce?

Or will we even see a period like the 1970s? Some assumed we will. But besides the loose monetary policy then, there were other triggers such as surging oil prices, labor costs, and political maneuvers. And the magnitude of these issues is more severe than what it is today. Back in the 1970s, the world is dealing with OPEC which supplies 50% of the world's oil and labor unions were a lot more powerful. The complete dissociation of the USD from Gold also led to a weakening of the dollar and the corresponding rise in commodity prices.

We don't have a crystal ball to foresee what will happen. So the best approach is to not try and second guess what is going to come next. Instead, we should build a robust portfolio diversified across different asset classes and strategies. That would give us a better chance to weather through the different regimes that might come our way.

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