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.
Adding a 40 per cent allocation of gilts to a UK equity portfolio over this period obviously would have added to the portfolio’s income paying capabilities, but it would also have provided the benefit of reducing the portfolio’s volatility of annual real returns by one-third from 14.6 per cent to 9.7 per cent with only a 40 basis points annualised sacrifice in real total return (6.4 per cent portfolio real return for the 60-40 portfolio vs 6.8 per cent for the stocks only portfolio).
When the global financial crisis hit in 2008 and the pandemic in 2020, bonds rose in value while stocks fell.
But during the stagflationary 1970s the picture could not have been more different. From the end of 1971 to the end of 1981 gilts lost 44 per cent of their real value as inflation soared. Moreover, when stocks were hit in 1973 and 1974, so too were bonds.
This reminds us of the difficulty of investing during stagflation. The right stocks will be key to generating income and the right stocks are the innovators.
James Dowey is co-manager of the Liontrust Global Dividend fund
