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Be aware of stagflation

If you have not heard of the term "stagflation", this post serves to get you to start paying really close attention to it. This could possibly be one of the most important things you read this week.

What is stagflation? Stagflation is an economic condition where you have all the ingredients of a perfect storm: slowing economy, high unemployment rate, high inflation. Some might confuse stagflation with recession. They are largely rather similar with one big difference- high inflation exists in stagflation. During normal recessions, you see sluggish economic growth and also a high unemployment rate. However, buying power might still be relatively unaffected as inflation remains low. In stagflation, you get whatever you are seeing in recession with an extra punch- and that is your buying power getting increasingly corroded due to inflation. In some sense, a stagflation is even trickier than a recession.

And this has been proven in history.

In the 1970s, US experienced almost a decade of stagflation. Inflation was at an astounding rate of ~13% in 1979 and the unemployment rate is also high during the same period. Now you might be thinking how could this be possible? Shouldn't unemployment rate and inflation be inversely proportional? Well, that's what many economists used to believe though.

When the Fed decides to pour money into the economy to drive demand for goods and services, the prices of goods increases (a result of too much money chasing too few goods). Seeing that the prices of goods increase, workers would expect their wages to rise accordingly. While this might be sustainable at the beginning with employers willing to raise wages, it should prove to be unsustainable when inflation starts to outpace the wage increases. Employers then stop increasing the wages of workers to be higher than inflation, and workers are unwilling to accept lower wages (in relation to inflation). Hence, unemployment then rises- bringing you the perfect storm of high unemployment and low interest rates.

And this situation could likely happen again if we are not careful this time round.

To combat the economic impacts of COVID-19, central banks are injecting liquidity at a rate which we have never seen before and governments are increasing deficit spendings more than ever. We also now have interest rates being reduced to negative real rates. These could very well potentially give rise to inflation later down the road if we are not careful (again, too much money chasing too few goods). In fact, there are already signs that food prices are beginning to creep up above headline inflation rates. At the same time, economic performance is not exactly expected to do well in the future as we can see from the Gross Domestic Product (GDP) forecasts. As the dismal economic conditions persist, companies are more likely than ever to lay off workers- giving rise to unemployment rate. This in fact then results in a vicious cycle as people will reduce their spendings and that further slows down economic growth.

All these points to the fact that there is a likelihood we could end up in the economic condition which we all dreaded- stagflation. And as investors, you need to be especially careful about this.

During periods of stagflation, the high interest rates diminish the values of low-yield investment vehicles like bonds. Returns on riskier assets like stocks could also be lower as stock valuations would take a dive amid the dismal economic conditions and investors tend to look for safer assets which are more inflation-resistant. In the period (1970-1979), the S&P500 provided a return of 5.9% annually while the inflation in the same period was 7.4% annually. Hence, you are losing money every year for a decade if you are only vested in the broader stock market. This further reiterates the importance of diversification. If your entire portfolio is only made up of stocks and bonds, you have no effective hedge during periods of stagflation.

In an earlier article which I wrote, I highlighted a few textbook examples of recession-proof portfolios. These portfolios could also potentially be stagflation-proof. Now, notice that these few portfolios have something in common. Besides stocks and bonds, they also included commodities. And if you have been watching the news recently, you could have noticed that gold has been silently creeping up over the last few months. It has even surpassed the previous highs seen in 2011. (I have wrote an article on gold in March about the possible inclusion of gold in your portfolio to combat deteriorating economic conditions.) In stagflation, gold is an excellent safe haven for investors to avoid having their portfolio returns eroded by inflation. Like what I usually said to readers or people around me, the best ship you could have in turbulent waters is the one which is built in gold.

With the likelihood of stagflation increasing, I couldn't stress any further the need to consider allocating your portfolio to ensure the investment vehicles you are having are not all positively correlated to each other and balancing them on a regularly basis to ensure you are having a healthy and proportionate mix of different class of assets to achieve a good return on your investment in terms of CAGR, sharpe ratio and max drawdown. Some of these are discussed in an earlier article here.

If you are wondering what are the key indicators to look out for to determine if we are at any risk of stagflation, do monitor the Consumer Price Index (CPP) and Produce Price Index (PPI) to look out for signs of inflation and also Gross Domestic Product (GDP) for signs of economic recovery.

Till the next time. Stay balanced.

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