FTAdviser.com

Advertising

The national newspapers ran dramatic front page stories in May suggesting the “spectre of stagflation” could once again haunt policy makers for months, if not years, to come. The trigger was that the official measure of inflation had reached 3 per cent, up from 2.5 per cent the previous month.

In July, that measure soared to 3.8 per cent and in the latest figures it stands at 4.4 per cent, against an official target of 2 per cent. Other inflation measures are worse: factory-gate prices are now rising at 10 per cent a year – their highest rate since 1986 – and input prices have reached a 30 per cent year-on-year increase, exceeding the peak rates of both oil shocks in the 1970s.

An inflation shock is unwelcome at the best of times. Coming on top of a credit crunch that has triggered sharp drops in residential and commercial property prices, which would ordinarily have triggered aggressive interest rate cuts, is seriously bad news. It is no wonder UK consumer confidence has dropped to recessionary levels.

The unhelpful combination of rising costs and slowing growth is reminiscent of the 1970s and it is not just a UK phenomenon. A similar problem confronts central bankers in all of the large developed economies, from the US to Europe and Japan, as unprecedented emerging market demand drives commodity prices higher.

Stagflation is a notoriously difficult environment, but there are precautions that investors can take to limit its impact on their real net worth.

History shows that certain asset classes perform better in different economic conditions. This applies in stagflation as it does in any other environment. If an investor is able to correctly identify where we are in the economic cycle, they can tilt their investment portfolios to exploit whatever assets history suggests have fared better.

Investors can use an “investment clock” approach to assess what stage of the investment cycle we are in, with the position on the clock face determined by the strength of global growth and the direction of inflation.

The first phase of the cycle, “reflation”, is characterised by weak global growth with falling inflation. Government bonds offer the best returns as central banks cut interest rates and inflation expectations drop. The two-year period from January 2001 is a recent example.

After what economists call a “long and variable lag”, interest rate cuts work their magic and economic growth recovers. Corporate profits surge but spare capacity in product and labour markets keeps inflation on a downward tack. The combination of strong profitability with low interest rates makes this early “recovery” phase the sweet spot for equities, as we saw for a year from March 2003, and over the twenty year bull market that started in 1980, when developed economy inflation dropped from double digits to low single digits.

At some point, strong growth leads to bottlenecks of one kind or another. Prices rise and central banks raise interest rates to head off inflation pressures. Commodities generally offer the most attractive returns during this “overheat” phase, as we saw from 2004 onwards.

When central bank rate hikes take effect, something cracks. Last time around it was the dot.coms; this time it was the US housing market and financial instruments linked to sub-prime mortgage debt. Growth slows but inflation pressures can linger on like the hangover after a party as supply shortages and late-cycle wage increases persist. The “stagflation” phase we have been in for a about a year is the time to be defensive. Profits are being squeezed as volumes fall and costs rise, but central banks are very reluctant to cut rates for fear of stoking inflation expectations.

According to analysis of the US economic cycle, stagflation has been on the radar screen five times since 1970 for a total of 86 months. In each of these periods defensive investments have been proven to perform best. Cash outperforms other asset classes more often than not. Even then it may not preserve your wealth in real terms. The US Federal funds rate stands at 2 per cent with inflation at 5 per cent.

Commodities do well, but with a degree of risk because demand for raw materials is generally easing off. Back-testing also reveals which stock sectors have proved most effective. They too are defensive and non-cyclical; oil and gas, pharmaceuticals and utilities. Tobacco rises to the top as the ultimate defensive value beating even oil and gas.

The investments to reduce are those that do best on the opposite side of the clock, when growth is strong and inflation is falling. Stock markets tend to struggle in stagflation, with consumer discretionary stocks, financials and property the worst hit areas.

But, of course this analysis should not suggest a total shift of assets – that would introduce unreasonable risk and transaction costs. Moreover, we cannot be completely sure which phase of the cycle we are in. Where the investment clock theory is most effective is in diverse, managed portfolios with the flexibility to adjust asset class and sectoral weightings to exploit all economic periods.

So where next? First, there will be a slowdown in the developed world which, in turn, will hit emerging markets and commodity prices. Next, inflation will fall and interest rates will be cut, moving us into bond-friendly “reflation”. Given time, real estate prices will recover and banks will start to lend again, allowing a new “recovery” and a new bull market in stocks to establish itself.

The good news is, we may be seeing early signs of stage one, with the oil price off its highs amid a sharp deterioration in continental European economic data. The bad news is that we are barely into the first of these three phases today, so a defensive asset allocation continues to make sense.

Trevor Greetham is manager of the Fidelity Multi-Asset Strategic fund