What Is ‘Stagflation’?

Stagflation is an economic phase represented by slow growth, high unemployment rate and rising prices. What makes it challenging for policymakers to balance is that addressing one problem may intensify the other.

Probably the first-ever reference to this economic phenomenon was back in 1965 when Iain Macleod MP told the House of Commons that Britain was facing the worst of both worlds: “Not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of stagflation situation.”

Now, 60 years on, the term ‘stagflation’ is back on the agenda in relation to the UK economy. Here’s a closer look at how stagflation affects stocks and shares investments, and what investors can do about it.

Toxic mix?

There is no hard-and-fast definition for what stagflation actually is. But it is generally agreed to exist when challenging slow economic growth coincides with rising prices.

Graham Bishop, chief investment officer at Handelsbanken Wealth & Asset Management, says: “Stagflation means different things to different people, but we take it to mean weak or negative economic growth and rising consumer price inflation, to levels above central bank targets.”

In a recent note, the National Institute of Economic and Social Research (NIESR) – the UK’s oldest, independent economics think tank – said the UK had suffered from five years of “lost economic growth”, with stubbornly high inflation and semi-permanent government deficits forecast for the foreseeable future.

Jagjit Chadha, NIESR director, said the UK’s economic woes had led to the “re-emergence of the British disease” – a reference to the stagflationary trap of the 1960s and 70s.

UK consumer price inflation soared during 2022 to a 40-year high of 11.1% in October of that year, according to the Office for National Statistics (ONS). What’s more, rising prices have continued to linger at way in excess of the Bank of England’s 2% target during the first half of 2023, a knock on from the damaging economic cocktail caused by soaring energy prices, global supply chain problems and the ongoing Russian invasion of Ukraine.

Meanwhile, the latest gross domestic product (GDP) figures from the ONS – a measure of how the economy is performing – have barely moved in recent months. The combination of high inflation and a stalling economic recovery suggests that the UK is teetering within stagflation territory.

Why is stagflation a problem?

A healthy, growing economy provides the government with more revenue to spend on public services such as the NHS and transport or, if it chooses, to cut direct taxes.

A period of stagflation is considered dangerous because a challenging economic environment results in decreased spending power. Throw in high inflation and the overall effect applies extra pressure to the economy as consumers’ money loses value over time.

What does stagflation mean for investors?

David Morrison, senior market analyst at Trade Nation, says stagflation is bad for investors: “Prices rise, while wages fail to keep up. Consumers cut back on spending. Corporate profits fall and jobs are cut. Government costs rise, while tax receipts decrease. Borrowing costs increase and a recession follows. Can it be avoided? It can probably be postponed, but recessions are an inevitable part of the economic cycle.”

Max Rofagha, CEO & founder of Finimize, says: “The last time we were faced with stagflation was 1973 when energy prices were also sky high and when an oil embargo led to an economic recession and significant stock market correction.”

Poppy Fox, investment manager at Quilter Cheviot, warns: “Rising prices and weaker economic output is not a good scenario for most people, including retail investors.”

Kasim Zafar, chief investment strategist at EQ Investors, says stagflation is one of the most challenging environments for any investor. “Low or falling economic activity levels are a revenue headwind for most industries, while high or rising inflation increases costs. Hence, profit margins face a double whammy.”

How does stagflation affect the stock market?

Ms Fox says: “Stagflation presents a danger for equities. Inflation and weaker demand have all the makings for a potential reduction in corporate profit margins which hits the share prices of those companies. Negative sentiment on the outlook for equities can weigh on markets and thus share prices.”

So what can stock market investors do to help protect themselves financially?

Alice Haine, personal finance analyst at Bestinvest, cites defensive sectors: “They generally cope better during a period of stagflation because they are made up of companies whose products and services are considered essential. Or their business models are linked to long-term contracts or government order books, such as infrastructure investments and defence companies.

“People still need to buy food, pay their utility bills and look after their health whether inflation is high or not, so investing in consumer staples, utilities, and healthcare can make sense when an economy slows.”

EQ Investors’ Kasim Zafar agrees that the consumer staples sector is a good one to consider. “Equity investors should focus on higher quality businesses that sell goods and services that are considered staple items by both consumer and business customers.”

Zafar says staples range from toothpaste to critical software subscriptions and licences: “Although customers may trade down from one brand to another, depending on their level of disposable income, it is unlikely they will stop buying such products and services.”

Time in the market

In addition to focusing on particular sectors, it’s important to bear in mind that investing in the stock market should be regarded as a long-term exercise, at least five years and preferably longer.

Bestinvest’s Alice Haine says: “The best strategy for investors right now is a long-term approach, one where they drip feed money into a diversified portfolio at regular intervals, such as monthly or quarterly.

“While the temptation during periods of uncertainty might be to sell up and move into cash, the key here is to focus on time in the market rather than timing the market. Market falls are to be expected during your investment journey.”

Full tilt

Ms Fox says: “While inflation is high you can always tilt your portfolio to investments that are likely to benefit from rising prices. This could be energy firms or those businesses with strong pricing advantage who can more often than not pass on any increase in costs to the consumer.”

However, Fox adds that investors need to remember that markets are forward-looking and that much of the present inflationary environment is already baked into the share prices of firms. “While it is beneficial to identify companies and funds that could do well in the current environment, these may not be the winners in six to 12 months’ time,” she warns.

Annabel Brodie-Smith, of the Association of Investment Companies, says: “In these tough conditions, it’s important investors have a diversified portfolio, take a long-term view and if in doubt they should talk to a financial adviser.