Investing in Times of Stagflation

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Inflation, and particularly stagflation, exacerbates the difficulty of investing.

Stagflation occurs when inflation is excessive but growth is insufficient or negative.

Cash and bonds are obviously undesirable investments, as their yields are frequently lower than the rate of inflation in an inflationary environment. A bond is a promise to pay a specified amount of currency in the future, thereby diluting the purchasing power of that currency.

Frequently, stocks do not fare much better. When currency's purchasing power is relatively stable, it makes it easier for businesses to plan for the future, enter into long-term contracts, and so on. When the currency is unstable, planning becomes much more difficult. While a company's revenue increases as it increases prices, its expenses also increase, and it's difficult to predict which will increase faster, revenue or costs. Additionally, as bond yields rise, they put upward pressure on highly valued stocks.

Real estate typically performs better than stocks and bonds, even more so if the property is financed with a fixed-rate mortgage. Typically, the house price (asset) increases with inflation over time, while the fixed mortgage (liability) depreciates. This is conditional on valuation; in inflation-adjusted terms, a given house price may stagnate for an extended period.

Industrial commodities (e.g., oil and copper) typically benefit the most from inflationary conditions. By almost definition, high inflation indicates that commodity prices are increasing. Typically, commodities are undersupplied during inflationary periods, and it frequently takes years to add sufficient new supply, weighing on real economic growth and contributing to a stagflationary situation. Commodities, on the other hand, can be extremely volatile, with sharp pullbacks occurring even in favorable environments for them.

Monetary commodities (such as gold and bitcoin) tend to correlate with inflation over time, but not always at the precise moment of high inflation, as industrial commodities do. Gold, in particular, tends to perform well during stagflationary periods, when economic growth slows but inflation remains relatively high. Additionally, it typically outperforms equities in outright recessionary/deflationary environments.

This article delves into some of the complexities surrounding asset performance in inflationary environments.

Inflationary Pressures and Resource Constraints

Inflation is a term that lacks a precise definition. It varies according to which school of economic thought one examines.

Monetary inflation is the expansion of the money supply. If the number of monetary units increases faster than the availability of various real-world resources (commodities, supply chain capacity, and available labor, for example), prices for various goods will generally rise. This is because demand for real goods and services exceeds supply.

On the other hand, we can examine commodity capital expenditure cycles to determine when commodities are structurally over- or under-supplied. Additionally, we can perform this function for global or regional supply chain capacity. Thus, if the number of monetary units remains constant while we destroy half of the world's shipping ports and oil production facilities, the price of remaining shipping capacity and oil production will skyrocket.

This is complicated further by the way economists measure inflation. They group a variety of goods and services into a weighted basket and estimate how the basket's price changes over time. They gradually adjust the basket's weighting and the calculations with hedonic adjustments and so on, which usually results in a decrease in the official estimated level of price inflation.

Generally, technology is deflationary over time, as it improves efficiency. For example, software and electronics continue to improve in price and quality. Additionally, engineers have reduced the cost of manufacturing basic items such as clothing and shoes through automation and globalization. However, technology is not universally applicable, and occasionally, whether as a result of war, malinvestment, or simply commodity capex cycles, we take a step back and become less efficient for a period of time, becoming more inflationary in the process.

The greatest inflationary periods in history have typically been characterized by a combination of monetary inflation and supply-side bottlenecks. That is why, even after supply-side bottlenecks are resolved and inflation's rate of change stabilizes, prices for the majority of goods remain permanently higher; the amount of money in the system remains permanently higher.

For instance, inflation spiked in the United States during World War II. Although the rate of change eventually stabilized, the level of prices for broad goods and services remained permanently elevated.