The Stagflation Scenario: Defining It and Adapting Asset Allocations

09 November 2021

10 min read

Inigo Fraser Jenkins| Co-Head—Institutional Solutions

Over the past month, we’ve seen growing commentary about the possibility of stagflation, exacerbated by a flattening of yield curves. Stagflation is not a central case in our outlook, but clearly investors regard it as more of a risk, so it should at least be discussed for holistic portfolio planning.

We distinguish between tactical stagflation and a strategic case for stagflation. Over tactical horizons—the next 12 months—growth and inflation might evolve to a period where inflation and growth rates “cross over.” But we don’t think this really counts as stagflation in any traditional sense: the absolute growth level will still be very high, given current high demand. And we still believe that the exceptionally high inflation levels, by some measures, are transitory.

Room for a Higher-Inflation Scenario

A bigger question for asset owners is whether the macro landscape points to a possibly longer stagflation period over the next three to five years, which would be a major shock to current strategic asset-allocation assumptions. This scenario wouldn’t be driven by the temporary supply/demand shock fueling exceptionally high short-term inflation, but by the longer-term prognosis for growth and inflation.

How likely is this scenario?

We’ve made the point several times that strong inflationary and deflationary forces exist over strategic horizons. In our central case, these forces lead to equilibrium inflation that’s above the pre-pandemic level but still in “moderate” territory. However, no one knows what coefficients to put on these forces, because we’ve never been in this state before. That leaves room for a higher-inflation outlook, which requires watching for several key forces—in the strategic, not tactical outlook.

Strategic Forces That Could Stoke Higher Long-Term Inflation

An ongoing demographic transition implies a shrinking global labor force (excluding Africa, at least), which will likely undo a significant portion of labor-supply growth that occurred in the wake of former Soviet countries and China joining the global economy. This could imply stronger wage bargaining power in the medium term. There’s a lively debate about how much of this is likely to be offset by automation, especially given indications that investment in automation has accelerated in the pandemic era.

A force that could drive wages up faster than demographics is change in social and political mores—notably the narrative about the relative power of labor and capital as well as the “leveling up” agenda in terms of wage inequality. These forces seem set to materially affect the wage distribution and increase labor’s share of gross domestic product (GDP) in coming years. As we’ve discussed before, this could lead to some form of universal basic income, which could mechanically set a higher path of inflation. Putting this in the language of the investment industry today: ESG is inflationary.

Above and beyond this, the pandemic’s legacy of higher debt levels and the ability to deploy fiscal policy as the key offset to economic slowdowns could alter the inflation calculus. We view imposing austerity in major economies as politically impossible, so over the medium to long term, politicians (though not central bankers) will likely look more favorably on higher inflation as a way to manage down debt levels, which, as a percentage of GDP, are now the same as they were at the end of WWII across the countries in the Organisation for Economic Co-operation and Development.

Moreover, the fiscal genie is out of the bottle. Whenever the next downturn comes, there will presumably be intense pressure on fiscal policy to provide support. There’s a debate about whether this would count as Modern Monetary Theory (MMT) or not—we believe that this is slightly beside the point and merely semantics. It’s highly unlikely that MMT will be explicitly adopted as a stated policy in a major economy because it would require too much rebuilding of institutions. However, quasi-MMT language could be influential and used as a description to craft policy.

Defining Stagflation Scenarios—and Asset Responses

None of this necessarily leads to higher inflation as there are offsetting forces, but for those who worry about stagflation, these are the narratives to watch. In the near term, a key metric is how this wariness feeds into expectations of inflation, which have been increasing (Display).

Near-Term Inflation Expectations Are at A Historical High

US Conference Board: Consumer Inflation Expectations—Next 12 Months

Consumer inflation expectations over the next 12 months

Historical analysis does not guarantee future results.
From January 15, 1988, through October 15, 2021
Source: Datastream and AllianceBernstein (AB)

Stagflation requires a growth slowdown too. Tactically, there will inevitably be a slowdown in the growth run rate after the post-pandemic demand boost. But strategically, the key marginal growth drivers are the upward pressure from investment required for the energy transition against the downward pressure from a shrinking labor force.

No one really agrees on the exact definition of stagflation, and this ambiguity helpfully covers a wide range of outcomes across assets. We suggest three distinct scenarios:

Scenario One: Historic inflationary shocks that coincided with a sharp slowdown in real economic growth, with date ranges including 1Q 1970–4Q 1970, 1Q 1974–3Q 1975, 4Q 1979–4Q 1980, 1Q 1982–4Q 1982, and 3Q 1990–3Q 1991.

Scenario Two: A narrower definition of inflationary shocks and low growth looking only at periods where real GDP growth was less than 1% and inflation was more than 4%. Those include: 1Q 1970–4Q 1970, 1Q 1974–3Q 1975, 2Q 1980–4Q 1980, 1Q 1982–4Q 1982, and 4Q 1990–2Q 1991.

Scenario Three: Based on the changes in growth and inflation, this scenario focuses on the scenario one episodes but extends the time horizon to earlier quarters, when higher growth was beginning to slow and inflation starting to rise. This scenario includes only quarters where declining real growth coincided with rising inflation, including 3Q 1973–4Q 1974, 1Q 1979–1Q 1980, and 2Q 1990–4Q 1990.

The two Displays below show return sources that may help or suffer in stagflation periods. In the first, we show the average and median year-over-year returns quarterly for select asset classes with positive average returns in most of the three stagflation scenarios. We put extra emphasis on scenario three, which uses the change in growth and change in inflation, because that anticipatory period is probably most critical for investors today. In the following display, we show the average and median return of assets with mostly negative average returns in stagflation periods, again putting particular emphasis on the returns in scenario three.

Return Sources That May Help in Stagflation Periods

Year-over-Year Returns

Historical analysis does not guarantee future results.
Analysis covers the period from 1Q:1970 to 3Q:1991
Source: AQR, Datastream, Global Financial Data, Ken French database, Robert Shiller’s database and AllianceBernstein (AB)

Return Sources That May Suffer in Stagflation Periods

Year-over-Year Returns

Individual asset analysis hides some of the worst problems at the portfolio level. For example, in one of the underlying periods, from November 1973 to August 1974, total returns for US equities and bonds were negative—with strong positive correlation between them at the worst possible time.

We extend the analysis to account for varying risk levels of different assets (Display), showing average annualized returns during stagflationary periods adjusted for the overall volatility across the full return history since 1970. We note that real estate, in this case, is the Case-Shiller Index, so it’s not listed. This inflates the return/risk ratio because of the lack of mark to market, but we include it for completeness. Treasury Inflation Protected Securities (TIPS) and gold stand out with very high return/risk ratios in such periods, but, as we note below, that historical picture must be tempered by today’s relatively high TIPS valuations, though that’s not a problem for gold

Return/Risk Ratio of Key Stagflationary Return Streams

Trend strategies such as equity momentum clearly depend a lot on the path of returns. They tend to strongly underperform at turning points, but once a path is established—such as a higher movement in inflation—they deliver strong returns. The data implies that equity momentum is a good contributor to portfolio returns, especially in the run-up to one of the episodes shown here—scenario 3. However, one has to be ready to allocate out of the strategy rapidly once the trend breaks (Display). Momentum in fixed income has a less effective track record in these types of periods.

Trend Strategies Fare Well in Stagflation, but Be Nimble

Year-over-Year Returns

Historical analysis does not guarantee future results.
From January 1960, through December 31, 1985
Fixed income and FX momentum factors use the past 12-month cumulative excess-of-cash return on an asset and the factor portfolios skip the most recent month’s return. Equity momentum factor shows the market-cap weighted return of a portfolio that is long the top quintile–ranked stocks and short the bottom quintile–ranked stocks.
Source: AQR, Datastream, Ken French database and AllianceBernstein (AB)

Action-Point Considerations for Asset Owners

A coming period of stagflation is not our core view, but investors are right to consider this as a possible risk in their portfolio planning.

A few conclusions stand out when surveying a half-century of previous stagflation episodes defined in a number of ways. They’ve generally been weak periods for equities. The real winners have been return streams that are inflation protected and not linked to business cyclicality: TIPS and gold stand out in this respect. Commodities also do well (of course, commodities usually have a link to the cycle in normal growth periods). We would also suggest considering other forms of portfolio protection against high inflation, including real physical assets such as farmland, timberland and infrastructure.

Value equity strategies might be initially considered as an option, given that they tend to be effective as inflation rises. However, their stagflation record is patchy at best: many forces that drive value trades tend to be pro-cyclical, so declining growth in stagflationary periods tends to hurt. Also, value historically benefits from moderate inflation, but sharply higher movements can be damaging. The decline in growth is a performance drag on passive equity exposure overall, and a stagflationary period with sharply higher inflation passes the point at which moderate inflation is a “good thing,” raising the equity risk premium and depressing multiples.

From an equity sector perspective, healthcare and staples, as defensive sectors, have stood out once a higher-inflation/low-growth regime has been established. In factor terms, this has been a good period for the low-volatility factor within equities. However, if one focuses only on the run-up to stagflation periods, an even stronger performance showing comes from commodity sectors.

So, there’s definitely an opportunity to take a more explicitly pro-inflationary stance going into such periods. The sector that stands out as suffering at this juncture is banks, which is also why value-factor performance is more of a mixed picture if commodity sectors and banks move in opposite directions. These relationships make a stagflationary period different from a simple inflationary period.

Gold performs relatively well in stagflationary periods, pointing to the possibility that other non-fiat-denominated zero-duration assets could fare well, not least with today’s debt levels for major economies being significantly above those in the previous stagflation periods shown here. This points to a possible role for crypto assets in this scenario.

For investors interpreting this historical evidence today, the poor performance of equities in stagflation is worrying, given that equities are valued at close to the top end of their 140-year range and are already widely owned after a roughly US$1 trillion inflow. A stagflationary outcome would be a shock to those starting positions, indicating the need for reducing equity beta. Investors might seek to take cover in private equity, but in our view, that could be a mistake. Private equity valuations are at historic highs and these assets still share equity beta over the cycle. It is only the marking-to-market that can create a useful fiction of uncorrelated returns, but we think an extended stagflation period would likely burst that.

The knee-jerk reaction might be to buy even more TIPS. Evidence from prior stagflation periods is consistent with that choice, but we can also show that TIPS are the most expensive form of inflation protection, with valuations 2.5 standard deviations expensive versus their historical averages dating back to the end of 1971. So, while TIPS are low risk in a sense, they would also likely lock in much lower returns than in previous stagflation episodes.

A Barbell Approach to Stagflation Protection

While stagflation is not our base case forecast, investors concerned about that risk to the outlook might want to consider a barbell if stagflation becomes a reality. A higher allocation to TIPS and gold would be the lower-risk part of the response, combined with an allocation to cross-asset factor strategies as well as select physical real assets and commodities.

There are also opportunities for adjusting equity sector positioning, with commodity sector exposure going into a stagflation period, then switching to healthcare, consumer staples and an equity low-volatility factor once higher inflation becomes established. The overall equity weight should be reduced too. We also think that lower expected returns from key passive asset-class exposures could open up more opportunity for idiosyncratic return to play a role in portfolio allocation.

As a more radical suggestion to those who might be able to entertain such a view, we also think crypto assets should be considered as part of that allocation, we just don’t know whether they should count as being in the high-risk or low-risk part of the barbell in such a scenario!

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

About the Author

Inigo Fraser Jenkins

Inigo Fraser Jenkins is Co-Head of Institutional Solutions at AB. He was previously head of Global Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Fraser Jenkins headed Nomura's Global Quantitative Strategy and European Equity Strategy teams after holding the position of European quantitative strategist at Lehman Brothers. He began his career at the Bank of England. Fraser Jenkins holds a BSc in physics from Imperial College London, an MSc in history and philosophy of science from the London School of Economics and Political Science, and an MSc in finance from Imperial College London. Location: London

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The Stagflation Scenario: Defining It and Adapting Asset Allocations

Room for a Higher-Inflation Scenario

Strategic Forces That Could Stoke Higher Long-Term Inflation

Defining Stagflation Scenarios—and Asset Responses

Action-Point Considerations for Asset Owners

A Barbell Approach to Stagflation Protection

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