Interactive Investor

What is stagflation and how can investors protect portfolios?

7th September 2022 11:52

Kyle Caldwell from interactive investor

Stagflation is bad news for both equities and bonds. Although, as ever, there will be both winners and losers in the respective asset class. 

There’s no shortage of comparisons between 2022 and the 1970s; soaring inflation, rising interest rates, geopolitical tensions and a wave of strikes by public sector workers.

While a recession is likely to be added to that list later this year, a more concerning prospect is a sustained period of stagflation. This occurs when a country experiences slow economic growth at the same time as high inflation. Its last prolonged appearance was in the 1970s.

Brian Tora, an associate at wealth manager JM Finn, points out: “Recessions and stagflation – the S word – do not happen that frequently. Economic management has improved massively in recent years, so we must hope a way may be found to avoid the worst-case scenario.

“An early resolution to the conflict in Ukraine would undoubtedly help, although this is looking far from likely. Resolving supplies of energy and fuel is probably easier to achieve than replacing the lost foodstuffs from Russia and Ukraine.”

Stagflation is bad news for both equities and bonds. Although, as ever, there will be both winners and losers in the respective asset class.

Shares

Economically sensitive stocks – those that are cyclical – are likely to be laggards. Whereas, defensive stocks that are masters of their own destiny, such as by having products or services that people view as being essential, are expected to fare better.

Tora points out: “The number one priority for investors wanting to protect portfolios against stagnation is to seek out investment that has a real return potential.

“Investors may like to diversify equity portfolio holdings with defensive stocks that can withstand increasing production costs and supply demand.”

A large part of the UK market contains defensive sectors and industries, a point made in a recent Insider Interview by Job Curtis, fund manager of City of London (LSE:CTY) investment trust, a member of interactive investor’s Super 60 investment ideas. Curtis said: “Utilities [are one defensive sector], as people have to carry on paying their water and electricity bills. Another example is pharmaceutical companies, and there are more resilient sectors such as tobacco.”

Peter Hewitt, fund manager of CT Global Managed Portfolio Income (LSE:CMPI), has recently purchased Finsbury Growth & Income (LSE:FGT), managed by Nick Train. Hewitt explained: “The companies held by Train are big global brand names that have the ability to pass on rising prices. If markets move in a sideways direction during a recession, I think the strategy will perform well in that environment. In a recession, the types of companies that can pass on price increases are the ones I want to have exposure to.”

While acknowledging there’s a risk of stagflation taking hold, Hewitt thinks a recession is more likely. His view is that inflation will fall, but that it will prove stickier in the UK than across the pond. He said: “If on a global scale inflation remained high while growth slowed, leading to stagflation, then you would likely see equity markets fall significantly. But I think it is unlikely to be a global phenomenon.” 

For a doomsday scenario of stagflation materialising Hewitt points to five investment trusts that are “protectors of capital” to give defensive ballast to a portfolio: Capital Gearing (LSE:CGT), Ruffer Investment Company (LSE:RICA), Personal Assets (LSE:PNL), RIT Capital Partners (LSE:RCP), and BH Macro GBP (LSE:BHMG), a hedge fund which seeks to take advantage of opportunities in interest rates, bonds and foreign currencies. Hewitt describes the latter as a trust that “thrives on volatility”. Hewitt holds 15% in total across the five trusts.

He added: “The common theme among the five ‘portfolio protectors’ is either no or low exposure to equities with the result that they offset other holdings in the portfolio that are affected in adverse market conditions.”

Bonds

Usually, bonds thrive in a recession as this normally leads to interest rate cuts, which causes bond prices to rise and yields to fall.

However, if high inflation persists the bond market is going to suffer. Inflation is the enemy of bond investors, as it erodes the purchasing power of the income that bonds generate.

Yet, following the bond market sell-off year-to-date, which has resulted in bond yields rising to their highest levels in years, it may not prove to be too painful. 

Vincent Ropers, portfolio manager of TB Wise Multi-Asset Growth, points out that if central bankers struggles to contain inflation, leading to further interest rate rises, a part of the bond market that will benefit is asset-backed securities. Ropers likes TwentyFour Income (LSE:TFIF), an investment trust that invests in high-yielding asset-backed securities, including mortgages and credit card debt.

He explains: “The asset-backed securities use floating rather than fixed rates – whereby coupons payable rise in tandem with interest rates – which offers a meaningful hedge against rising rates.”

Elsewhere, according to Ben Gutteridge, director of model portfolio services at Invesco “there could be money to be made from longer duration bonds” if stagflation materialises. Bonds with a longer lifespan typically offer higher yields, as they are riskier and more sensitive to rising interest rates.

Gutteridge explains that under this scenario interest rates would need to be aggressively hiked, followed by sharp drops when inflation has been successfully reined in. “If stagflation plays out further from here, the path for short-term interest rates is higher but for long-term interest rates it could well be lower.”

Therefore the opportunity is for bond fund managers to lock in the higher yields that long duration bonds offer ahead of interest rates falling, which would then cause bond prices to rise and bond yields to fall.

However, Gutteridge’s view is that inflation pressures will ease over the next six to 12 months reflecting base effects of commodity prices, supply chain frictions easing and a general softness in growth.

Alternatives

Ropers adds that stagflation would be “a very difficult environment to be in”, and that he would focus on having exposure to assets that offer protection against inflation.

As a hedge against inflation, history suggests commodities are one of the standout winners. However, during a recession there’s usually lower demand for basic materials. Fears of a recession and expectations that inflationary pressures are easing has led commodity prices to cool over the past couple of months.

If inflation continues to stay elevated, Ropers thinks commodity prices will go back up, in turn “providing some downside protection”. He owns BlackRock World Mining Trust (LSE:BRWM) and BlackRock Energy and Resources (LSE:BERI)

Ropers’ view is that inflation will cool, and that the recession will be “shallow”. He adds that when investing during a recession, diversification is key with some exposure to more defensive areas, such as healthcare and infrastructure. Both have predictable long-term cash flows. He holds Worldwide Healthcare (LSE:WWH), GCP Infrastructure Investment (LSE:GCP), JLEN Environmental Assets Group (LSE:JLEN) and Pantheon Infrastructure (LSE:PINT).

Commodities, healthcare and infrastructure are examples of “real assets”. As part of a diversified portfolio, real assets can help to reduce risk alongside generating income.

Andrew Hardy, a director at Momentum Global Investment Management, points out:History and theory would suggest that the best way to prepare for a period of stagflation would be to increase allocations to real assets, spread across key areas including commodities, infrastructure and property, and with a focus on those with more explicit inflation protection built into their revenue and cost structures.”

Two funds endorsed by interactive investor with exposure to real assets are FTF ClearBridge Global Infrastructure Income and FP Foresight Global Real Infrastructure, in the Super 60 and ACE 40 lists.

A final point, made by Hardy, is that a higher-than-usual allocation to cash would be beneficial to take advantage of the buying opportunities that a period of stagflation and weakness in markets eventually creates.

He adds: “Timing markets is notoriously difficult though; instead, we advocate a long-term and well-diversified approach, and at this point would emphasise that a lot of bad news is already discounted in markets, such that selling and locking in this year’s losses may well prove the wrong thing to do.

“While the 1970s was a painful decade for equity investors, at the eventual lows, it created one of the best multi-decade buying opportunities ever seen in markets.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.