Russia’s invasion of Ukraine, which has devastating human consequences, has increased the risk of an environment of stagflation, characterized by slowing economic growth but high inflation.
How should investors prepare for this possible scenario? Our analysis reveals which asset classes are likely to outperform if this materializes.
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In general, there are four different phases of the economic cycle depending on the evolution of production: recovery, expansion, slowdown and recession.
The table below shows the average (inflation-adjusted) real total return of major asset classes for each phase of the business cycle in high inflation environments.
Historically, the downturn has favored investment in traditional inflation hedges such as gold (+19.3%) and commodities (+16.7%).
It makes economic sense. Gold is often seen as a safe haven and therefore tends to appreciate in times of economic uncertainty.
Commodities, such as commodities and oil, are a source of input costs for businesses as well as a key component of inflation indices. Thus, they generally work well when inflation is also rising (often because they are the cause of rising inflation).
By comparison, the downturn proved very difficult for equities (-0.6%) as companies struggled with falling revenues and rising costs.
Keeping your savings in cash (-0.2%), represented by treasury bills, was not a better strategy.
Although US Treasuries have performed well in the past (+6.4%), they should be treated with caution today.
In theory, they should benefit from the fall in real rates, driven by the decline in growth.
However, rising inflation is eating away at their incomes, putting upward pressure on yields and downward pressure on prices.
In practice, the extent to which this hurts bond yields will depend on their duration and initial yield (higher yields provide a bigger cushion to absorb rate hikes).
What are the main lessons of asset allocation?
Last year, the reflation environment favored investment in risky assets such as equities and commodities, while gold suffered.
This is in line with what we expected using our previous analysis. However, if we are on the cusp of a period of stagflation, a shift in performance leadership could be underway.
In this scenario, equity returns could turn lower while gold and commodities could outperform. This is exactly what has manifested so far in 2022.
Meanwhile, central banks are stuck between a rock and a hard place. Raising interest rates too quickly could plunge the global economy into recession. But keeping rates low for too long could cause inflation to spiral out of control.
Overall, the bond outcome is uncertain and will depend on the tussle between inflation and growth sentiment.