Coronavirus: A Stagflationary Supply Shock?

The unfolding supply shock from COVID-19 could see a more pronounced period of stagflation than that of the 1970s / early 1980s. Commodities can outperform other financial assets in such an environment by avoiding the rising risk premia and negative real rates impacting traditional financial assets.

Stagflation, a term coined in and still associated with the 1970s and early 1980s, is an economic environment in which growth is disappointingly weak, yet the price level steadily rises. This normally occurs when a negative ‘supply-shock’, such as a spike in imported energy prices, a trade war, or slump in productivity growth, hits an economy. While a net negative for headline growth, this can also place upward pressure on prices even as growth weakens.

Accommodative monetary and/or fiscal policy to counteract the negative effects of a supply shock on growth makes it all the more likely that price inflation remains elevated or rises. This stands to reason: Economic officials might be able to ease monetary and fiscal conditions, thereby preventing a more severe downturn, but few would argue that they are able to reverse the negative impact of a supply shock on productivity.

Stagflation Hurts Both Equities and Bonds

Stagflation creates a hostile environment for investors, albeit depending on the scale and mix of monetary and fiscal policy response. Growth disappoints, implying that equity multiples decline, yet rising inflation likely results in higher bond yields. If the central bank holds nominal interest rates below the rate of inflation in order to support growth, cash erodes in real value. If the government issues more debt, the supply could lift term premia, placing further upward pressure on bond yields.

The above describes much of the 1970s. It didn’t play out all at once, and in fact the stagflationary effects of the 1973 supply shock had not yet fully dissipated when a second shock arrived in the late 1970s. The result was a large spike in both unemployment and inflation. The so-called ‘Misery Index’, which adds up both, soared to over 20% in 1980.

Equity markets struggled during these years. Share values did not keep pace with rising inflation, thus declining in real terms. By the early 1980s, the P/E multiples of the major US stock market indices had fallen to single digits. But equities still outperformed bonds as companies were able to push some of their rising costs through to consumers and bond yields were carried higher by the rising inflation.

Commodities Outperformed During 70s / Early 80s

What was a terrible decade for financial assets, and even for cash, was however a strong decade for commodities. While investors don’t normally consider commodities to be defensive in nature, they become so in a stagflationary environment. Profit expectations and equity valuations suffer during stagflation as rising input costs and weak or negative productivity growth hit profit margins, amplified further by slowing economic growth.

Commodities provide a way for investors to avoid both the underperformance of financial assets in such an environment as well as the negative real interest rate on cash balances. Gold and other precious metals investments are the traditional way in which to protect real wealth during such environments. But investments in energy infrastructure and in some cases agricultural projects did rather well during the 1970s.

Chart 1: Oil and Gold Outperformed in the 70s/80s

Source: Bloomberg, Federal Reserve

Coronavirus Shock Comes at a Time of Relative Financial Weakness

History may not repeat, but it rhymes. No two supply-shocks are the same, and economies adjust dynamically to each, hopefully becoming more resilient to future challenges. However, there are times when already fragile economies are hit by shocks, resulting in particularly bad outcomes. Were many economies today not carrying such unusually high debt levels, public and private, there would be more room for fiscal manoeuvre to offset the current Coronavirus shock. Similarly, were interest rates not already at zero, or even negative, central banks would have more straightforward policy ammo too.

Due to the prolonged policy responses to the endogenous shock provided by the global financial crisis over a decade ago, many economies now find themselves facing an exogenous one from a position of relative financial weakness and instability. Nevertheless, all signs are that policymakers will aggressively deploy their respective toolkits in efforts to reduce or reverse the damage Coronavirus could do to growth prospects. Therefore, it is not too much of a stretch to speculate that the supply shock currently unfolding might be even more stagflationary than portions of the 1970s. If so, this would likely have clear implications for the relative performance of commodities versus financial assets over the coming quarters.

John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)