We believe that such companies are the best income stocks in the market in today’s economy and will navigate stagflation the best. We see many of the classic types of income stocks today as structurally vulnerable to disruption through innovation and unable to adapt. They may pay enticing high yields, but those yields are high for good reasons. In many cases, stagflation would likely be the final straw for them.
Stagflation and interest rates
A consideration for our thesis that innovators are the best stocks for stagflation is that innovators are growth stocks and growth stocks would not like the rising interest rates that would likely feature in a stagflationary world. We think the lasting impact of stagflationary rising rates on innovative companies would likely be a lot less than is sometimes argued.
If bond yields rise simply as compensation for higher inflation, then all that really matters is a company’s pricing power, so that its cash flows rise as the stock market’s discount rate rises. And we would rather have an innovator’s pricing power (like Estee Lauder), or alternatively its ability to substitute new cheaper inputs (like Costco), every single time.
Meanwhile, the low-growth side of stagflation would tend to keep the real component of interest rates – and so discount rate of stocks – naturally subdued. Even if things got tougher and central banks waged war on the economy by dramatically jacking up policy rates as they did in the 1970s, then we would favour the resilience of better, more innovative companies to navigate those challenging conditions, though stocks would likely be unpleasantly volatile for a time.
Stocks and bonds
If stagflation comes back, then equity income investing will be a very important thing to get right. This is partly because bonds have been everybody’s best friend for a very long time now, delivering income, a lot of capital growth and low correlation to stocks. But under stagflation, they would be the bad guys.
We looked at the real (inflation-adjusted) returns of the UK stocks and gilt indices constructed in the Barclays Equity Gilt Study. The period since 1982 has been a golden age for bonds, with gilts delivering a 5.8 per cent annualised real return with 8.4 per cent volatility and a correlation co-efficient for annual returns with stocks of 0.1.
