Adapting to the risk of stagflation shock

In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we suggest that the risk of a stagflation is rising and that investors may need to reposition their portfolios in light of new risks.

The whirlwind of excess fiscal stimulus, the demand shock and surging inflation have been fuelling the persistent inflation narrative. Now with commodity prices on an uptrend, two risks are added: inflation and recession. This situation could create the perfect storm for a potential stagflationary environment. So how can investors prepare for this scenario?

Stagflation refers to an economy with little-to-no growth and higher than normal inflation. With the recent exponential increase in commodities prices, as well as the Federal Reserve’s (Fed) March meeting revising growth downward (2.8% now versus 4% in December), the investment world must acknowledge the fact that we are facing a potential stagflation shock. Stagflation is not yet today’s core scenario, but the odds of it are increasing. An additional risk is that such a shock becomes a longer lasting cycle. Chart 1 illustrates economists’ expectations regarding growth and inflation in 2022 in the US and Europe. In both regions, economists predict an economic slowdown and rising inflation during 2022. This suggests an increase in the probability of a stagflationary regime without necessarily implying stagflation itself. Indeed, the Fed’s decision to combat inflation with eight rate hikes while consumers’ cost of living and corporations’ progressed costs are rising could create a recession without curbing inflationary pressures enough. However, the current discourse points towards an inflationary regime rather than a recession. We consider which risk premia are appropriate for each of these environments.

Chart 1. Economists’ expectations regarding growth and inflation in 2022

Source: Bloomberg, LOIM

Different asset classes perform more or less well depending on the economic regime. Using our in-house regime dating methodology, Chart 2 presents the regime-specific Sharpe ratio for different risk premia in excess of their long-term value. This is a traditional way of investigating which risk premia may help to hedge different risks. The analysis here covers the 1992-2021 period and includes the inflation shocks of 2011, 2016 and 2022, as well as the recession shocks of 2008 and 2020.

This analysis shows that in times of inflation, the following risk premia have usually delivered positive excess Sharpe ratios:

• Traditional risk premia: Inflation-linked bonds (ex-duration), precious metals, global equities, energy and emerging credit would have been effective hedges.
• Alternative risk premia: Equity momentum and size factors, fixed income carry and commodity backwardation worked well.

And in times of recession the following risk premia were effective:

• Traditional risk premia: government bonds and the US dollar (as a trade-weighted basket).
• Alternative risk premia: Equity quality and trend following.

This type of analysis can provide support for nervous investors. Depending on the risk scenario, these historic sensitivities can help identify sources of diversification for multi-asset portfolios. Combining these different risk premia can then provide a way to smoothly navigate such regimes.

Chart 2. Sharpe ratios (in excess of trend) of traditional (left) and alternative (right) risk premia during inflation and recession shocks (1992-2022)

Source: Bloomberg, LOIM. Based on proprietary regime dating methodologies.

Unfortunately, as shown on Chart 2, the risk premia which perform well during an inflation shock do not tend to do so well during a recession shock. The performances of most asset classes during these economic regimes are negatively related. If the scenario was as clear as the central bank’s resolve (inflation regime), investors should favour inflation hedging assets. However, in our view, the reality is more uncertain and might point towards stagflation. In this light, how should investors position their portfolios to sustain performance against such opposing forces?

When uncertainty prevails between two such risks, and given the opposing risk premia performance, there remains one asset that can be a refuge for investors who perceive both risks to be an equal source of concern: cash. Cash is historically an excellent hedge against stagflation: an analysis of the 1970-1980 period would not conclude otherwise. Investors should view this seemingly boring asset class as a safe haven in times of high uncertainty. Cash is particularly interesting today as central banks are enacting their hawkish arsenal. Eight rate hikes in the US will translate to improved performance for cash and there are comparable expectations for Europe.

Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

In the US, this week saw another series of strong macro data. Using the latest available data, the economic situation in the US remains solid. Building permits and housing starts posted strong numbers, respectively reaching +1,859k (versus 1,850k expected) and +1,769k (versus 1,700k). The Philadelphia Fed survey was also high in spite of its usual volatility (27.4 versus 14.5 expected) and the capacity utilisation rate (77.6% versus 77.9% expected) has reached peak levels (once de-trended) adding one more argument to the Fed’s decision to favour inflation over growth. The Richmond Fed survey (-11.8 versus 6.4 expected) however is at odds with the Kansas Fed, translating into macro uncertainty remaining elevated. The Federal Open Market Committee projections pointed to the current commodity shock having a -1.5% impact on US growth, meaning growth in the US could revert back towards potential more rapidly than expected.

In the Eurozone, the key data point has been inflation once more. Globally, year-over-year inflation remains at high levels, unchanged from last month (but French 12-month rolling inflation saw a decline). It is worth noting that half of European inflation can be attributed to the rise in energy prices. Otherwise, growth news remains limited. In Germany, the ZEW survey highlighted the mounting bearishness among investors, regardless of the ongoing solid economic data in the single currency zone. 

In China, growth numbers are improving tepidly. Fixed asset investments are rising, albeit partially for base effect reasons. They have jumped from 4.9% to 12.2%. Retail sales on the other hand plunged from 12.5% to 6.7%. The announced fiscal stimulus and central bank support should help see a stabilisation of the economy if not an improvement.
Factoring in these new data points, our nowcasting indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. US investment data points to a firmer growth cycle, pushing our nowcasting indicator north. The Chinese growth indicator has also started to give more supportive signs – although these are only early signs if anything.
   
• Inflation surprises should remain positive. The recent inflation reports and commodity volatility feeds into a higher world indicator. 
   
• Monetary policy is set to remain on the hawkish side, except in China. This follows the Fed meeting and the progression of investment data feeding in this indicator again. 

 
World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)
  
World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)
   
World Monetary Policy Nowcaster: Long-Term(left) and Recent Evolution (right)
   
Reading note: LOIM’s nowcasting indicator gathers economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
 

RISERVATO AGLI INVESTITORI PROFESSIONISTI

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