What a Mild Stagflation Scenario May Mean for Investments
Last year was a banner year for AIMCo and for its clients. Markets were supportive of pro-risk investments like global equities due in large part to COVID-era monetary and fiscal policies. Today, however, this has changed as both equities and fixed income have simultaneously underperformed in anticipation of interest rate increases (and their subsequent effects) in a high-inflation environment.
Now, a worrying mix of high inflation and slowing economic growth is causing some concern about stagflation, a situation where prices are high, economic growth slows significantly and unemployment increases.
In a recent article, three macroeconomic scenarios were presented about what could transpire in Canada’s economy and abroad. At AIMCo, we think a mild stagflation environment is the most likely situation to emerge, but how might markets react? And what could be in store for three key asset segments in this cumbersome macroeconomic environment?
Despite the very recent change in sentiment in light of national inflation releases, the broad market sell-off this year has increased risk among equities. In a mild stagflation environment, this sell-off would continue, especially in the United States, for a couple of reasons. First, U.S. equities would be hardest hit by mounting recessionary pressures that stagflation would certainly create. This would be due to U.S. equity markets having a less significant inflation-sensitive, resource-oriented sector relative to Canadian equities, for instance. High inflation, slow growth, and an increasing employment rate would impact American business earnings and cash flows across sectors harder than is the case now, leading to a broader and perhaps stronger market sell-off.
In addition, despite the relative (and current) U.S. economic strength, U.S. equities are still expensive compared to other regions. The recent price declines haven’t been accompanied by a material downward adjustment to earnings estimates and haven’t exposed further downside risk as earnings expectations adjust to the new economic environment. This would change in a stagflation scenario. The relative higher valuation and profitability risks of investing in America mean that when faced with high inflation, rising unemployment and slow economic growth, equities would drop more significantly, leading to significant losses.
Fixed income products have been unable to offer the usual diversification benefits in portfolios and have lost value in real terms recently (after adjusting for inflation). But as interest rates may continue to rise, bonds are becoming a little more interesting again for those looking to lock in higher yields and steer away from the uncertainty in public equities. In a stagflation scenario, the resiliency of the more discretionary parts of the economy will be tested. Overall, bonds could offer better value and better yields as fixed income would regain its traditional downside hedging capabilities. Yields are the main driver of fixed income returns over the long term and the higher yields also provide a better income cushion during the stagflation market selloff.
More importantly, rising yields in a mild stagflation environment would mean that the reach for yield which characterized the last few years would be behind us. There would also be a greater emphasis on credit quality for all types of fixed income investments.
In past downturns like the dot-com crash and the Great Financial Crisis, private equity demonstrated more resilience in the face of economic downturns compared with other asset classes like public equities. In fact, some of the strongest years for private equity were during these recessionary years.
In a mild stagflation environment, private equity would offer opportunity for institutional managers and investors alike. Opportunities would arise due to declining valuations and other breaks that often emerge during downturns.
In addition, the investment horizon for private equity and other illiquid assets like real estate, infrastructure and renewables are inherently longer term than the other asset classes. At any stage of the business cycle, private equity and illiquid assets should be thought of as strategic assets from a total portfolio perspective. They will especially play a critical role as diversifiers in a stagflationary environment due to the opportunities that may arise alongside their inflation-hedging properties, each to a various degree.
In conclusion, in a mild stagflationary environment, Canadian and other commodity-exporting regions’ equities are relatively attractive, at least compared to the U.S. Similarly, rate-hedged real return bonds and credit within fixed income, and private equity, infrastructure, real estate and renewables are all preferred exposures.
This article contains forward-looking statements with respect to economic conditions. Such statements address future events and conditions, and therefore involve inherent risks and uncertainties. Although AIMCo believes that the expectations and assumptions on which the forward-looking statements are based are reasonable, AIMCo can give no assurance that such statements will prove to be correct. Accordingly, AIMCo disclaims any and all responsibility for the continued truth of such statements at any future date.
This article is of a general nature only and does not purport to take into account all considerations that may be relevant to any particular individual or organization. As such, this article is not intended to be, nor should it be construed to be, investment advice to any particular individual or organization.