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BLOG: Beware the ‘s’ word…stagflation

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Written by: Brian Tora
15/07/2022
It’s hard to escape from the devastating impact inflation is having on society with the soaring cost of living. As stagflation concerns arise, here are ways investors can shield portfolios.

The aftereffects of the pandemic and the war in Ukraine have combined to place upward pressure on a wide range of goods, most notably in fuel, energy and agricultural products – areas where there is little discretion available as to whether, or not we choose to maintain consumption.

With additional pressures due to the recent political turmoil only just being factored into the markets, we are still in major flux and investors will no doubt be reading this hoping to protect their portfolios from the ‘s’ word – stagflation – a contracting economy amid high inflation.

Just recently, the UK economy surprised us with 0.5% growth in May, which many would think indicates economic prospects are improving. I’d take that news with a pinch of salt due to the fact the year-on-year jump was in large part due to post-pandemic holiday bookings.

In contrast, a more accurate gauge of whether stagflation is persisting is to look at the UK retail sales figures. These fell for the third month in a row in June, suggesting stagflation is alive and well as people continue to tighten their belts.

Rein in the rise in the cost of living

At a domestic level, we are already seeing calls for greater support for beleaguered families faced with higher living costs outstripping any rise in their income. Pressure is mounting for governments to introduce measures to help mitigate these rising costs, but it is difficult to see anything other than token assistance being made available.

Political instability won’t help, and wage inflation could be just around the corner, though this would only exacerbate the situation. Paralysis in Westminster won’t stop unions threatening strike action if wages are not raised.

Clearly the preferred solution is for governments and central banks to introduce measures to rein in the rise in the cost of living. The big concern that many economists have is whether such action taken to calm inflationary pressures will tip the global economy into recession. Traditionally the main weapon to be employed against a rising cost of living is higher interest rates. Already we are seeing rate rises here and in the United States, while the European Central Bank has indicated that it will also be raising the cost of money.

This can only add to the pressures being felt by many consumers, with mortgage costs likely to rise. Interest rates have been so low for a lengthy period that many homeowners have much larger borrowings in relation to their incomes and the value of their property than once used to be the case. The natural consequence of such a squeeze on incomes would be for spending to be diverted away from discretionary areas, which is likely to impinge on economic growth.

Central banks feel they must act, even if the rate rises will still leave the cost of money way below the prevailing inflation rate. The worst-case scenario is stagflation. The effect of this is to intensify the squeeze on disposable income, thus reducing the spending power of the average consumer – something that is already taking place.

Breaking out of such a cycle will not be easy, but it will be high on the agenda for those governments faced with this problem. What is more difficult to judge is the extent to which what is taking place now is a natural consequence of recent events with a finite life, or a major shift in expectations of how inflation should be viewed for the future.

If the former, central banks will doubtless be more moderate in their actions and may even manage to avoid recessionary conditions. It is the latter scenario that will be giving those tasked with managing the economy sleepless nights.

Recessions and stagflation do not happen that frequently. Economic management has improved massively in recent years, so we must hope a way may be found to avoid the worst-case scenario. An early resolution to the conflict in Ukraine would undoubtedly help, though this is looking far from likely.

Resolving supplies of energy and fuel is probably easier to achieve than replacing the lost foodstuffs from Russia and Ukraine.

What can investors do to protect from stagflation?

Investors will be wearily monitoring the developing situation, all wanting to protect their portfolios against stagflation. The number one priority for investors currently, is that they must seek out investment that has a real return potential.

Investors may like to diversify equity portfolio holdings with defensive stocks that can withstand increasing production costs and supply demand. Others will lean more on returns from commodities that are uncorrelated with stock market. This is because commodity prices usually rise when inflation is high, therefore investing in commodities may provide portfolios with a hedge against inflation.

Brian Tora is consultant at wealth manager JM Finn

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