Commentary: The return of stagflation?

The unprecedented fiscal and monetary stimulus provided by central banks and governments in response to the COVID-19 pandemic has prompted a fascinating debate in economic circles between those who see the sudden and widespread impact on consumption precipitated by the crisis as having a deflationary effect, and those who view inflation as the inevitable result of the unprecedented supply shock and injection of capital into developed economies.

They could both be right; we could have deflation at first and then transition to inflation later. The combination of deflation in the near term could suppress economic growth and the development of inflation in the medium to long term could erode capital — leading to stagflation.

What is stagflation? We define stagflation in a way that is of most relevance to pension plans: the combination of sustained high inflation and prolonged stagnant economic growth, which leads to persistent erosion in the real value of asset owner portfolios.

The five shaded periods in Figure 1 highlight prolonged periods where inflation significantly outstripped growth. These periods would be problematic for traditional long-only equity and bond portfolios.

The first four periods were the result of U.S. wartime activity, which saw the U.S. expand monetary supply substantially and purchase goods faster than they were being produced in many cases. The fifth period was markedly different from previous ones. Not only was it the longest, but its causes were rooted in external oil shocks and misguided monetary policy.

The potential implications of a stagflationary environment on asset owners' portfolios can be profound but there are solutions that can be put in place to mitigate its effects. Given the low likelihood of stagflation occurring but its impact being profound, a stagflation risk mitigation solution needs to produce useful returns during non-stagflationary periods, which is something that long-only allocations to commodity markets fail to achieve.

Instead, we argue that a commodity-heavy trend-following system combined with multiasset cross-sectional carry models as well as short-term alpha trading strategies can provide a well-rounded solution for traditional portfolios during stagflationary periods.

It is essential to remember that the foundations and anatomy of each stagflation period are different, with each period also featuring once-in-a-generation events.

Consequently, we cannot rely on prior stagflation period returns as our sole guide.

What should be considered when designing a portfolio solution to mitigate the risk of stagflationary environments?

• We should focus on the inflationary aspects of stagflation by analyzing the inflationary resilience of assets and strategies.
• Assets and strategies that tend to keep pace with U.S. inflation irrespective of economic growth should be emphasized within a stagflationary investment solution.
• Overall performance also matters; we need to ensure assets/strategies do not harm portfolios if stagflation does not materialize.
• Previous stretches of stagflation have compelled extraordinary central bank action, e.g. drastic fast-paced short-term interest hikes during the early 1980s. A stagflation solution design should be able to withstand this stress and possibly even take advantage of it.
• The onset of stagflation and associated central bank reaction could easily create short or longer periods of market instability. It is worth considering solution components that can respond to mitigate unsteadiness and tail risk.

Commodity futures, oil and gold have demonstrated inflationary resilience but the major risk of over-reliance on commodities for inflation hedging comes in the form of muted or negative overall risk-adjusted performance over longer-term time frames. These traditional long-only assets are unlikely to be enough for an effective stagflation solution.

A more robust stagflation solution needs to extend beyond traditional long-only assets and focus on the following:

• A well-balanced combination of alternative investment strategies may allow one to benefit from varying dynamics across asset classes without being overexposed to inflation risks.
• Strategies with sound theories or evidence surrounding their ability to perform during inflationary regimes. Examples would be multiasset cross-sectional models harvesting relative carry effects — particularly in fixed income, foreign exchange and commodities.
• Strategies that should not necessarily rely on U.S. growth only and should be implemented globally in a scalable and liquid manner. An example would be a global, multiasset, long/short, directionally unbiased (not long- or short-biased) liquid trading strategy that is not heavily weighted on U.S. equities or U.S. fixed income, either a globally diversified multiasset trend strategy or a multiasset global short-term tactical trading strategy.

A good solution needs to not fail catastrophically should stagflation not materialize. So while we expect trend following to work well in a stagflationary environment, it is also able to navigate non-stagflationary environments. Additionally, one ought to consider the possible ancillary effects of likely central bank actions that seek to combat inflation or the mere threat of significant inflation. Central banks could choose to let inflation run for a while as that will erode their debt obligations, but eventually that inflation will need to be addressed — most likely via significant rate hikes.

Higher interest rates have been known to hurt commodities such as gold due to the increase in opportunity cost as gold does not yield anything. Trend-following strategies on the other hand can navigate rising yields by unbiasedly capturing directional opportunities wherever they occur, including shorting bond futures.

We can only speculate on how central banks would react to a revival of inflation, but it's not inconceivable that inflation will not manifest itself everywhere at the same time and that could very well create global central bank policy divergence, thus leading to new and varied dislocations throughout the global cross-section of term structures within asset classes that could be harvested by relative carry models.

A final ancillary effect that we would like to highlight is the potential for market instability during periods of stagflation.

The addition of shorter-term strategies designed to capture opportunities in expanding volatility environments — whether these strategies are operated on liquid futures or option markets — would offer useful complementary performance to traditional assets in the early stages of market instability — regardless of the source of the market instability.

Razvan Remsing is director of investment solutions and Hakeem Gbadebo is an investment solutions analyst at Aspect Capital Ltd., London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.