What does Stagflation do to the stock market?
On February 24, 2022, Russia invaded Ukraine. This move led to a sudden and dramatic shift in stock market dynamics. The U.S. market saw an initial boom, with investors fleeing the Russian market for fears of an economic crash and impending sanctions. This led to various stocks performing relatively well or poorly with no clear direction.
Investment portfolios have suffered from significant undervaluation. This markdown has occurred because of the indiscriminate selling of high valuation stocks. A sign of Stagflation is high inflation. During periods of high inflation, the environment and regulation introduced can cause consumers to panic. When consumers decide to sell at relatively high valuations in fear of their investments losing value, it is likely to distort the stock market. These measures are taken in reaction to stagflation fears. Investors with stock portfolio holdings that rely on sectors with robust pricing power are often better able to navigate inflationary environments.
When the stock market changes direction, it is often seen as self-correction. A decline in the market can be the reversal of any prior overvaluation. Global events such as war or a pandemic can lead to economic supply shocks in sectors like energy and labor. These are vital areas and can cause high-performing stocks to decline in value, making them a cheap buy. When the effects of the economic supply shocks move into the past, the high-performing stocks will likely return to their proper positions.
There will also be some sectors that thrive during certain economic conditions like Stagflation. Delivery businesses saw rises in profit due to lockdowns introduced in various countries worldwide. These companies’ stock may skyrocket during this period due to high profitability. The main challenge, however, is that when the economy returns to normal, these businesses will become overvalued. The market will then self-correct, and investors will devalue these stocks.
Stagflation is rare and last occurred in the 1970s. In 2022, the U.S. economy diversified its energy sector well enough to prevent short-term supply shocks. The economy is far less energy-intensive currently. This feature means that the GDP produced by Americans required less than half the amount of fuel needed during Stagflation in the 1970s.
Investment Implications
The key to surviving the stock market during Stagflation is asset allocation in ever-changing conditions.
Investors will need to store value in assets that trade in commodities. Known as “real assets,” these investments are less profitable but carry less risk during Stagflation. The key examples investors turn to are our real estate and infrastructure. These offer the most reasonable chance of appreciating during an inflationary or Stagflation environment. Sectors that have stood the test of time, such as pipelines, refineries, and other infrastructure, often produce high earnings even during a stagnating economy.
Consumers will also need to take care when reading financial statements. Given the inflationary environment in the economy, it can be detrimental to underweight equity and credit exposure. Assets in the balance sheet may look low because of inflation. The company earnings and corporate balance sheets may be consistently rising; however, this is undervalued because of the present economic conditions.
During Stagflation, value equities are likely to look more attractive than long-duration growth stocks. Many consumers will seek to go with businesses with future solid cash flows. These cashflows should always be discounted to match present and expected inflation rates.
S&P 500 performance during Stagflation
The Standard and Poor’s 500 (S&P 500) is used to gauge the performance of the 500 large companies listed on exchanges in the United States. It is used to reflect the fears of past periods of Stagflation on stock valuations.
As fears of Stagflation grow across the U.S., consumers are looking to tighten up their investment portfolios to prevent value loss. When Stagflation occurred in the 1970s, the S&P 500 was heavily affected. The S&P 500 dropped by a median level of 2.1% during most stagflation periods. These quarters were often marked by high inflation and high unemployment. Conversely, In periods without Stagflation in the economy, the S&P 500 has risen by a median level of 2.5%. This statistic informs us that there is a loss of value during Stagflation and that stocks grow in their absence.
S&P 500 companies that do well during Stagflation often pass on rising inflation costs to consumers, mainly energy and industrial firms. Companies that own their supply chains can maintain competitiveness even during a stagnating economy.
Stagflation 1970s stock market
During the 1970s, the U.S. experienced a period of Stagflation that turned stock markets around the world volatile. The popular consumer index S&P 500 fell almost 40% between 1973 and 1974. Investors panicked and sold off stock indiscriminately of its performance. These high-performing stocks would eventually bounce back five years later and reclaim their high valuations.
Inflation is expected in every economy; however, it is often seen as a long-term problem. Short-term inflation spikes can erode profits significantly in a relatively short time frame. Payouts in the form of dividends are distributed on an inflation-adjusted basis. During Stagflation in the 1970s, U.S. stocks lost 1.4% per year. This data is the opposite of the high returns the U.S. stock market provided investors over the past twenty years. The expected comparable return was often well over 14.0% before Stagflation.
The S&P 500 companies saw profits grow by 9% annually during Stagflation; however, it was eroded by inflation. Investors feared the economic stagnation would be long-term, so they sought out commodity-based businesses. By the decade’s end, the S&P 500 had a PE ratio of just 7.5.
The conclusion is that traditional investments were underperforming during the stagflation period of the 1970s. “Real assets” such as gold provided higher returns for investors.
What kind of stocks do well in Stagflation
- Real estate
- Value stocks
- Gold and silver
- Commodities
- Cryptocurrency