The coronavirus pandemic, coupled with the Russian invasion of Ukraine, has created a unique economic environment. Now, many are wondering if we’ll see stagflation in 2022.
What is stagflation?
Stagflation is a rare economic phenomenon that’s caused by high inflation coupled with slow economic growth and rising unemployment. 📊 It doesn’t come around very often, but when it does, stagflation can have a direct impact on your investments.
Under normal circumstances, slow economic growth would usually lead to rising unemployment, but rising prices and higher inflation would not normally go alongside these two factors. 📈 As a result, stagflation creates a unique challenge for the economy.
What causes stagflation?
Stagflation is caused by a perfect storm of negative economic conditions. ☁️ Remember, for stagflation to set in, there needs to be high inflation, stagnant or negative economic growth, and rising unemployment. Stagflation is most impactful when it occurs as a reaction to a large-scale economic shock, like the coronavirus pandemic.
Other factors like supply shocks and government policy can also play into creating the perfect environment for stagflation to set in.
High inflation
High inflation, or rising inflation rates, means that the cost of living is steadily increasing over time and money is effectively worth less than it was a year ago. You might sometimes hear that when inflation goes up, the ‘purchasing power’ of your money goes down. 💸
As a result, people might start to spend less because things are more expensive. This might cause industry to slow down, as people turn their focus from saving for a holiday or their next big purchase, and shift it towards their everyday outgoings and essentials like food, water and other utilities, energy and medicines.
Slow economic growth
Slow economic growth is caused, at a very top level, by falling aggregate demand. Aggregate demand is the total demand for goods and services in an economy and it’s closely linked to GDP and is sometimes used as an overall barometer for economic health.
If aggregate demand is falling, it means there are fewer consumers and economic productivity will start to slow down as people won’t be buying as much. As a result, growth could plateau and the economy will eventually begin to contract.
Rising unemployment
Rising unemployment is the third main factor behind stagflation. If the economy is shrinking and consumers are buying less, companies might start to cut back their workforce in line with reduced demand for their products. Rising unemployment could result in even more dramatic declines in consumer demand, which can mean that economic contraction worsens. 📉
To combat stagflation, employment will need to rise – which in turn will increase the number of consumers in an economy. More consumers will help to increase demand, which will help to fuel expansion and should contribute to reverting the effects of slow economic growth. But, the nuance here is that increased demand could have an adverse effect on inflation – possibly driving it higher.
Supply shocks
Supply shocks can also help to bring about stagflation. A negative supply shock is an unexpected event that causes disruption to the supply of a good, service, product or commodity – which can result in a sudden rise in price, assuming that demand remains the same.
There are also positive supply shocks, which result in an increased supply – although these are rarer than negative shocks. The Russian invasion of Ukraine in February 2022 caused a negative supply shock for a range of different materials and commodities.
Economic policy
A final cause of stagflation, and one which feeds into wider economic metrics like inflation, economic growth and unemployment, is economic policy. Economic policy is simply a name for government spending or other frameworks that are designed to influence economic conditions.
For example, banks might increase interest rates to try and reduce the effects of inflation. But, this will push up the cost of borrowing – which means that people will have to cut on their spending in order to repay their loans – including their mortgages, if they’re on a variable rate. 🏡
How to combat stagflation
There’s no sure-fire way to combat stagflation, and there are multiple economic theories about the best course of action. The one with the widest consensus is that productivity and industrial output need to increase – which should lead to higher growth and lower unemployment – without pushing inflation higher. 🧑🏭
As a rule of thumb, cutting interest rates will lead to more consumer spending and economic growth because there’s less incentive to save – but this could have the knock-on effect of causing inflation to rise as demand for goods rises, pushing prices higher. On the other hand, increasing interest rates will help to reduce inflation – but it will also reduce economic growth as people are more incentivised to save their money rather than spend it, which will bring demand down.
So, policy makers and central banks will often look at combating each of these problems – rising inflation and slow growth – separately. They’ll also often do this over a long period of time to reduce the impact that tackling one will have on the other.
What does stagflation mean for your investments?
To look at how stagflation impacts investment returns, we need to break down different assets and how they have historically performed during periods of stagflation.
Research by Schroders* shows that the top performing assets during periods of stagflation are gold, other commodities and real estate investment trusts (REITs). Gold has posted average real inflation-adjusted returns of +22.1% year-on-year during periods of stagflation, while commodities have seen +15.0% and REITs +6.5%. 🤑 Stocks on the other hand, experienced drops of -1.5% on average, and bonds saw low gains.
Commodities tend to perform well during stagflation because stagflation is a local problem for an individual country to deal with. Commodity prices on the other hand, are set globally – so their prices are less susceptible to domestic economic conditions in one country at a time. The same goes for gold – because it’s in constant global demand, gold is less volatile during times of economic uncertainty. 🌍
| US stocksStocks, also known as shares or equities, represent units of ownership in a company. | Commodities | US bondsThe financial world’s version of an ‘I owe you’, bonds can be issued by companies or governments. You’d invest in bonds to receive an annual interest payment, plus the initial value of the bond back when it ‘expires’. | Gold | REITs |
|---|---|---|---|---|
| -1.5% | +15.0% | +0.4% | +22.1% | +6.5% |
Past performance is not a reliable guide to future gains. You may get back less than you invest.
How to invest during stagflation
If you’re already investing with Moneybox, you might want to make sure that your portfolio is effectively diversified – which will help you weather economic conditions like stagflation.
We’ve got a diverse range of funds that cover a range of areas including healthcare, property, and government and corporate bonds. We currently offer tracker funds and exchange traded funds (ETFs) – and our ETFs are available exclusively to our Stocks & Shares ISA customers.
If you have an ISA, you can change your allocation at any time in-app by going to Settings > Allocation > Change allocation. If you don’t have a Stock & Shares ISA with us, open one today to start growing your money with tax-free gains.
All investing should be long term (min. 5 years). The value of your investments can go up and down, and you may get back less than you invest. Tax treatment depends on individual circumstances and is subject to change
