Chronicle of April 2024
Asset Class Returns during Stagflation
Fear of stagflation is back. Which asset classes perform better during stagflation?
Stagflation is a period of high inflation and slow economic growth. During this time, unemployment is increasing and the cost of living is rising. Stagflation is more difficult to cure than a recession. In a recession, the central bank can simply decrease interest rates to stimulate economic growth; however, in stagflation, lowering interest rates can exacerbate inflation and drain people's purchasing power.
The latest economic data brought fear of stagflation. The U.S. GDP grew by 1.6% in Q1 2024, much slower than what consensus has predicted of 2.5% and lower than the same period last year of 2.2%. Meanwhile, inflation is still high, if not moving higher. March inflation was at 3.5%, higher than the consensus of 3.2%, and confirmed the upward trend since January.
It's still unclear whether the U.S. is on the verge of stagflation. Optimists will point to the low unemployment rate and thriving economy as reasons for the modest GDP estimates. For example, personal consumption increased by 0.8% month over month, indicating a healthy economy. However, the pessimist will refer to the growth in personal income, which increased by only 0.5% month over month. This means that consumers incur more debt.
However, anticipating stagflation is difficult because there aren't enough precedents to draw from. Stagflation in the U.S. has occurred only once in modern history, in the 1970s. The events around that time are peculiar. The Vietnam War and expanding social spending contributed to a dramatic growth in the U.S. budget deficit. Unemployment was high. Following Bretton Woods, the U.S. dollar was no longer tied to gold. And there was an oil supply shock as a result of the Arab oil embargo, which caused oil prices to rise to $150.
While many aspects of today's affairs bear striking similarities to those of the 1970s, there are also some notable distinctions: the unemployment rate is low, the U.S. dollar has long since been freed from its gold peg and enjoys "exorbitant priviledge," and the U.S. is currently the world's largest producer of oil.
But as investors, what assets should we buy if we can draw a lesson from the stagflation of the 1970s?
While equities have held up for most of the years, with the exception of 1974, their returns pale in contrast to gold. Commodity returns are also soaring, though not as much as gold. These make sense. A low-growth environment makes doing business more challenging, resulting in lower stock returns. It also reduces demand for commodities, resulting in lower returns compared to gold. During high inflation periods, people rush to gold as an inflation hedge.
Finger crossed; hopefully we are not going back to that era again.