Are we headed into a period of stagflation, and if so, why should you care?

In the ever-evolving world of economics, the term "stagflation" has been making its presence felt more prominently lately. Stagflation is a unique economic phenomenon with far-reaching implications across different asset classes and business sectors.

In this blog, we’re going to explore and hopefully answer (or at least better understand) the question above and explore its impact on various asset classes, discuss strategies to position for it should it happen, and address the question of whether we are currently entering a stagflationary period.

Make sure you read to the end where I share some perspectives on what business owners and investor in Australia might want to consider when navigating stagflation, should it occur.

What is Stagflation?

Stagflation is a perplexing economic scenario where stagnant economic growth, rising unemployment, and high inflation occur simultaneously.

Typically, inflation and unemployment move in opposite directions, but stagflation defies this conventional wisdom, making it a unique challenge for policymakers, treasurers, central bankers and businesses.

What drives Stagflation?

Stagflation can be driven by a range of external factors, such as a sudden supply shock or increase in oil prices which can lead to cost-push inflation.

This, in turn, reduces consumers' purchasing power and dampens economic growth. Additionally, supply-side constraints, fiscal mismanagement, or disruptions in the global supply chain can contribute to stagflation. As prices stay high and growth decelerates, unemployment starts to rise.

Currently, we are still suffering from increasing oil prices, supply shocks and declining household disposable incomes.

We also still have inflation that is running well above GDP growth, and which may come back in waves like it did in the 1940s and the 1970s where similar drivers were at play. What we haven’t quite seen yet is rising unemployment. That may still be to come. As a result, we are yet to enter a stagflationary period.

Can we predict it?

Historical growth, inflation and unemployment are easy to observe, but to predict where they will be 6-18 months out requires looking at leading indicators.

Real GDP growth is driven by demographics, productivity, and capital, where (a) productivity can be enhanced by technology to make up for widespread ageing populations; and (b) a lack of capital due to governments spending more than they earn can be enhanced with debt. In effect, predicting real economic growth is a function of debt, demographics and productivity and as a result, we can look to a mix of leading indicators such as PMIs, credit impulses, forward yield curves and cyclical versus defensive stock ratios.
For inflation, leading indicators include company pricing, M2 and even carriage/truck movements and freight rates.
Growth and PMIs can be leading indicators for unemployment, but fiscal stimulus and liquidity (measured by M2 and/or central bank balance sheets) need to be considered as we have seen over the past 12 months during which unemployment has remained resiliently low.

Hmmm, difficult, so can we look to the past for clues?

I was a teenager the last time we experienced stagflation here in Australia.

It’s a very rare beast.

But to show you what it looked like back in the day, here’s a table comparing the one period of stagflation we have so experienced since moving away from the dollar’s convertibility into gold, in 1972.

United States

During the late 1970s to early 1980s, the U.S. faced significant stagflation. Economic growth was subdued, with average growth rates hovering ~1.25%.

Simultaneously, inflation was persistently high, averaging around 8.85%.

This period was primarily instigated by oil price shocks, which heightened production costs and diminished consumer spending power. Unemployment rates in the US increased during this period, rising from around 4.9% to approximately 7.8%.

Australia

Australia encountered a similar scenario during the same era.

Economic growth rates in Australia were also muted, averaging around 1.10%. Inflation rates mirrored this trend, with an average of ~8.75%.

Like the U.S., oil price shocks and supply-side constraints contributed to Australia's experience of stagflation. Unemployment rates in Australia increased from about 5.0% to 6.2%.

Today, the inflation/growth spread is not as wide as indicated in the table, but the key point in that so far unemployment has not increased. It is resilient, so far and that’s probably because of the long reaching effect of COVID fiscal stimulus and the increase in M2 here and elsewhere.

Finally, it’s worth pointing out that when you have rising unemployment, along with high inflation and slow economic growth, it highlights the complexity of managing the economy because most traditional methods of arresting inflation can cause devastating effects to households that suffer even more as unemployment increases.

Thus far, we are yet to see the unemployment dial turn up. But, if central banks cannot get inflation under control and if growth continues to tank, leading to layoffs and higher unemployment - global treasuries and central banks will have one hell of a problem on their hands.

Implications for major asset classes

Here’s how the key asset classes behave during a slow growth/rising inflation/unemployment stagflationary environment.

Currencies: Stagflation tends to devalue the national currency due to inflation, making imports more expensive.
Fixed income: High inflation erodes the real return on fixed-income investments like bonds, bunds, gilts and treasuries, leading to decreased purchasing power. Bond prices typically go up as yields fall and floaters become unattractive.
Equities: Stagflation can negatively impact corporate profits and consumer spending, which may result in decreased earnings and stock market performance. Typically, some selective commodities, energy, utilities and consumer staples with minimum volatility/low beta work well.
Commodities: Some commodities, like gold and bitcoin can benefit from stagflation because interest rates are typically cut in an attempt to kickstart the economy. Low rates and high inflation create negative real yields, meaning there’s no penalty for holding non-yielding hard assets like gold and bitcoin, and certain commodity futures including agricultural commodities.
Real estate: Stagflation's impact on real estate can vary, depending on market conditions and investor sentiment and while interest rates are often cut during economic stagnations (positive for real estate affordability), there is also the problem of rising unemployment (negative for real estate due to declining loan serviceability).

Implications for businesses

Reduced consumer spending: Stagflation often leads to a decrease in consumers' purchasing power due to high inflation and stagnant wages. Businesses may experience reduced demand for their products or services as consumers cut back on spending.

Higher operating costs: Rising inflation can lead to increased production costs, particularly if a business relies on imported raw materials or energy. This can squeeze profit margins, especially if companies can't pass these costs on to consumers.

Uncertainty: Stagflation is characterised by economic uncertainty, which can make it difficult for businesses to plan for the future. Uncertainty about interest rates, inflation, and consumer behaviour can lead to cautious decision-making and mistakes.

Impact on investments: Businesses may need to reconsider their investment strategies. Capital investments in a stagflationary environment should focus on productivity improvements and cost control.

Taming Stagflation

To combat stagflation, policymakers in the past implemented a combination of monetary and fiscal measures.

But because Stagflation combines contradictory economic forces: inflation and unemployment, taming it requires policymakers to employ a combination of strategies that may include some of the below.

Tightening monetary policy: Raising interest rates to control inflation is a common approach. But this can also lead to higher unemployment and reduced household incomes/wealth, which adds to the economic and political complexity of addressing stagflation.

Fiscal policy adjustments: Government fiscal policies may need to be adapted to stimulate economic growth while maintaining price stability. This could involve infrastructure investments and tax policies that encourage investment. That said, these can be inflationary if pursued through fiscal channels and helicopter money/welfare (noting that we are still feeling the inflationary effects of the COVID fiscal largesse).

Productivity enhancement: Encouraging innovation and productivity improvements is crucial during stagflation to ensure businesses can maintain or increase output without significantly increasing costs. And it is this element that is in hot debate at present. Once camp argues that demographics and productivity are in terminal decline in most countries (barring India and one or two others) whereas the other camp believes that AI and robotics can plug the gap caused by rapidly declining workforces. We shall see.

That said, the above strategies need to be executed with a very careful balance of fiscal and monetary methodology if governments are to avoid fuelling the inflationary flames and killing growth.

And now we come to the Fraser years.

Remembering the Fraser Government

If you’re in my demographic, you might recall the criticism laid against the first Australian Prime Minister to face stagflation, Malcolm Fraser.

Fresh from dispatching Gough Whitlam from the big green chair, the Fraser government faced difficulties in effectively managing stagflation. Critics argue that his administration struggled to strike a balance between fiscal and monetary policies to combat high inflation and sluggish growth.

Some economists and political opponents pointed out that there was a perceived lack of coordination between the government's fiscal policies (related to taxation and government spending) and the Reserve Bank's monetary policies (related to interest rates and money supply).

But the Fraser government faced a politically challenging environment, including a divided parliament and external shocks like oil price increases. These factors limited the Fraser government's ability to implement effective policies.

That period of stagflation was eventually resolved, to some extent, through a combination of factors, most of which were outside Fraser’s control:

Global economic changes: A reduction in oil prices and improved stability in global energy markets helped ease one of the major factors contributing to stagflation.
Monetary policy adjustments: Central banks, including the Reserve Bank of Australia, implemented unpopular policies to curb inflation by raising interest rates and controlling money supply.
Structural reforms: Various governments, including the Fraser government, initiated structural reforms to improve economic efficiency and promote productivity growth.
Long-term economic shifts: As the global economy evolved, new industries and technological advancements helped boost economic growth and reduce the impact of stagflation.
Political Leadership: Subsequent leaders implemented policies that addressed the challenges of stagflation, contributing to improved economic conditions.

In summary, what we have learned is that resolving stagflation requires a combination of global economic changes, an effective balancing act between monetary and fiscal policies, structural reforms, and leadership that can adapt to the evolving economic landscape.

Are we facing another period of Stagflation?

The question of whether we are entering a period of stagflation is currently the subject of debate and this is why I decided to write about it today.

There are many schools of thought about when a recession might befall the U.S. and other counties, including Australia. Factors like energy prices, Russian sanctions, supply chain disruptions and China growth/credit impulse as well as technology advancements like AI and robotics plus black swan events like Hamas’ invasion of Israel, will continue to influence the direction of global economic growth, inflation and productivity.

Economically speaking, Australia is no island. Our growth and inflation levers are primarily pulled by China (biggest trading partner) and the USD (Reserve currency denominated almost all of our exports and contributing to inflation via imports prices).

As a result, and unless robotics and automation can increase the productivity rate faster than our ageing demographics are reducing growth, there is a moderate but real probability of Australia entering another (rare) period of stagflation, particularly if energy and shelter prices stay high. But there’s also a decent chance we may end up in a contractionary winter where we see slowdown in both growth and inflation. Or, if China decides on a super-size credit impulse, perhaps we will see a ‘no landing’ recovery.

The jury’s out.

But, here in Straya, the probability skews to stagflation if the RBA does not get on top of inflation with further rate hikes, and if the government continues its fiscal spending in place of a wilting China.

Strategies for business owners in Australia

To succeed during a stagflationary period, should it occur, Australian company owners should consider strategies such as diversifying income sources, adjusting pricing models to accommodate increased costs, and adopting technology to enhance productivity and efficiency.

Additionally, fostering resilience through financial planning and risk management is vital.

Here’s that TLDR in a little more detail for those of you who see stagflation as a real risk.

Flexible pricing strategies: Companies may need to adjust pricing models to accommodate increased costs. While raising prices, they should be alive to maintaining competitiveness and customer loyalty.
Diversification: Diversifying income sources can help businesses weather the storm of stagflation. Expanding into new markets or offering complementary products or services can mitigate the impact of stagnant sales in one area.
Focus on efficiency: Enhancing operational efficiency becomes critical. Streamlining processes, reducing waste, and optimising resource allocation can help businesses maintain profitability.
Debt management: High inflation can erode the real value of (fixed) debt, making it more manageable for businesses with outstanding loans. However, it's essential to carefully manage debt to avoid excessive interest costs.
Innovation and adaptation: Businesses should prioritise innovation to stay competitive. Adapting to changing market conditions and embracing new technologies can help companies thrive during stagflation. Robotics and automation are high on the list, and the sooner the better.
Risk management: Developing robust risk management strategies is critical. This includes hedging against volatile prices for inputs, considering supply chain diversification, and having contingency plans in place.
Employee retention: During stagflation, retaining skilled employees is crucial. Retraining or upskilling staff can improve productivity and reduce the need for costly hiring during uncertain times.
Cash management: Maintaining healthy cash reserves is prudent. Businesses should have a financial safety net to handle unexpected challenges and take advantage of investment opportunities that may arise.
Customer service and loyalty: In a period of economic uncertainty, exceptional customer service can be a key differentiator. Building strong customer relationships and fostering loyalty can help maintain revenue streams.
Government policies: Keep an eye on government policies and regulations that may change in response to stagflation. These can have a significant impact on your industry and business operations.
Long-term vision: While addressing immediate challenges, businesses should maintain a long-term vision. Strategies that balance short-term survival with long-term growth are essential for sustained success.

Final thoughts

In closing, productivity is a result of the interaction between various constituent parts, including land, labour, capital and entrepreneurship.

The precise mix and output of those factors in any particular industry in any particular sovereign state is driven by factors such as investment/debt, productivity improvements, international trade, government policies, geopolitics, innovation, and demographics.

Understanding these elements is essential for individuals and policymakers seeking to foster productivity, economic growth and development.

But every so often, due to a rare set of circumstances, we come across a strange beast called stagflation. This is when economic growth stagnates simultaneously with rising inflation and rising unemployment. Funky, right?

Well, it’s only happened once since dollar to gold convertibility ended in 1972, and while this means it’s rare, it does warrant your attention in case it happens again.

If it does, it will present you with some unique and contradictory challenges, opaque ripple effects and it will be difficult to resolve - just like it was when it hit Australia during the 70s and early 80s when inflation came in waves and toppled the Fraser Government.

So, if you assess the probability of stagflation occurring (perhaps in 2024) to be at least moderate, you should be looking for mitigants and making some astute tweaks now, in anticipation.

On the other hand, we might instead go into 2024 with growth and inflation both falling simultaneously, in which case we would end up with a garden variety contraction. Or, if China decides on a super-size credit impulse to stimulate building and real estate, perhaps Australian growth picks up and we end up in a ‘no landing’ recovery.

In any event, it’s critical to consider, question and retest your economic framework at regular intervals, because things are changing fast.

See you in those waves.

Mike

The curious case of Stagflation and why you should care