Higher risk of stagflation has implications for asset allocation. Investors should consider alternative asset classes such as real estate, commodity-related stocks, defensive stocks and perhaps gold.
David Bakkegaard Karsbøl, CIO at Selected Group In practice, all major movements in the financial markets are due to market participants being surprised by something. If everyone fears further tightening of monetary policy by central banks and expects a high inflation rate, a lower inflation rate will be received positively because that part of the fear turned out to be unfounded. We saw this last week.
Apart from monetary policy – which determines the price and supply of money – few things are as crucial to the valuation of financial assets as the economic outlook. Equity investors fear a recession more than almost anything else because corporate earnings typically decline during a recession. The combination of shrinking order books and fixed costs can quickly turn a good financial statement into a horror. And since stocks are usually valued according to their ability to generate earnings, this results in poor stock returns at the prospect of recession.
Conversely, for bonds, the prospect of a recession will typically lead bond investors to expect lower growth in consumption and investment and increased idleness in the production apparatus. This will weaken overall demand in society, leading to lower inflation and lower interest rates (which is the same as higher bond prices). As an investor, you should always consider the likelihood of a recession. You don’t want to buy stocks at a time when the stock market is priced above the pink clouds because everyone expects high and rising earnings and is willing to pay for access to high growth rates. Disappointments lead to lower share prices.
Conversely, buying shares at the prospect of recession can actually make sense at times because they are often cheaper when there is a consensus that earnings are at risk of weakening. In short, investing is therefore about guessing what everyone else will do before they know it themselves. And if enough market participants anticipate an imminent recession, it limits a negative outcome should it actually occur. At present, we have seen a fairly dramatic slowdown in global economic activity over the summer, and the slowdown is very likely to continue into the summer of 2023. Nevertheless, the stock market has so far performed reasonably well in recent months. This is probably because so many market participants have been expecting a recession for quite some time and have not been surprised by developments.
Since 1970, the US Federal Reserve has been collecting questionnaires from economists working to predict economic trends. At no time in these 52 years has such a large proportion (44%) of economists expected a recession within the next 12 months. Even just before the financial crisis, only around 25% expected an imminent recession. Against this backdrop, it seems that it will take major disappointments and economic downturns to really become a problem for equity investors in the coming months. Even though equities are still expensively priced – especially compared to bonds – we may well be close to the bottom in the stock market. In such a scenario, the stock market will not deliver impressive returns. The defensive sectors and so-called low-volatility stocks will probably deliver the best returns. Historically, the gold price has actually performed well during such periods.
Commodity-producing stocks will benefit from structural demand for raw materials for the green transition and the fact that the sector has generally been underinvested for several years. Homeowners should carefully consider whether they should take home the gains on their fixed-rate loans now. Interest rates have risen from 0.5% to over 3% in just a few months – a historic move. The prospect of higher monthly payments may not be so appealing, but my guess is that homeowners will be able to convert down to 2% within a couple of years – and even if that doesn’t happen because inflation remains elevated, greater wage growth could help pay for a higher payment. In terms of real estate, it benefits greatly from inflation as many leases are indexed to inflation. As rent levels rise, so does the value of the property.
However, interest rates have also risen in response to inflation, making financing more expensive and, all else being equal, pushing up the required rate of return (rent level divided by property value). Overall, however, I expect real estate investors to benefit from a stagflationary environment.