Yesterday we looked into the spectre of inflation and its terrible twin, stagflation. Today we examine its effect on the stock market and other investments in more detail. Including the best investment to make during stagflation.

Inflation not only causes economic trouble, as we dug into yesterday. It presents challenges for investors. Bonds, normally seen as relatively safe investments, no longer protect wealth, but rather erode it as their fixed coupons fail to keep up with rising prices. That said, investors can invest in inflation-linked bonds, which provide a degree of protection.

Stocks may still rise in price during the early phases of inflation. But once corporate profit margins come under pressure, they tend to do poorly. This is especially true if stocks are already trading at high price/earnings multiples, as is generally the case today.

When inflation morphs into stagflation as a result of chronic inefficiencies and poor productivity, a bad situation becomes even worse. Few may recall the 1970s and early 1980s in the UK, much of Europe and North America, but it was generally characterised by inflation, weak growth and rising unemployment.

Stagflation is a highly hostile environment for investors, a “worst-of-all-worlds” situation of bonds losing value due to inflation, and stock multiples compressing due to poor growth prospects. The impact on a typical 50-50 or 60-40 stocks-bonds portfolio can be severe.

While investors normally expect balanced portfolios to be resilient to normal business cycles, they are highly exposed to a stagflationary environment. And sitting in cash and waiting it out is not an attractive option either if the rate of inflation is running as high or higher than typical bank interest, as is the case today.

Preparing for stagflation

However, there are things that investors can and should do to prepare. First is to realise as above that, in a stagflationary environment, a typical portfolio of financial assets is not as well-diversified as conventionally believed. Both bonds and stocks can go down in price together. But the best-performing stocks are likely to be those of firms with pricing power – that is, the ability to pass along input cost increases to consumers.

Pricing power tends to exist where resources are scarce and/or purchases tend to be non-discretionary. For example, in the mining and refining industries for energy, other industrial commodities and precious metals. The same is also true to some extent for agricultural and transport infrastructure. In the 1970s/early 1980s, basic industries outperformed the broader market and precious metals mining shares did particularly well, but tech stocks languished.

Tech is a much bigger sector today, to be sure, and permeates most sectors of the economy in some way. But given current valuations relative to basic industries and the evidence of the past, tech might perform particularly poorly this time round if stagflation returns.

Building the stagflation portfolio

One of the most important actions to take heading into stagflation is to add precious metals to a portfolio of financial assets. Gold and silver might pay no interest, but in real terms neither does cash, and bonds lose value outright as inflation expectations increase. Yet precious metals also don’t default, and their prices tend to at least keep up with if not necessarily outperform inflation over time.

As their prices also tend to move somewhat independently of both stocks and bonds, they increase the diversification benefits of a portfolio and stabilise returns. A simple exercise in passive portfolio analysis demonstrates this. Looking at the past few decades, adding 10-15% precious metals to a portfolio of stocks and bonds reduces the volatility.

It doesn’t necessarily improve average returns, until you include periods of stagflation in the backtest, which results in a substantial improvement. Adding in both the lower volatility and the higher results in a portfolio that, even in the highly challenging 1970s and early 1980s, would have remained remarkably stable and generated double-digit returns in most years.

No one can predict the future, but everyone needs to try to prepare for it. For those concerned with the current wave of inflation building across the globe, a stagflation-oriented portfolio of pricing-power stocks, precious metals and at least a partial shift from fixed to inflation-linked bonds could provide some reassurance.

It’s no surprise, then, that my friends at Fortune & Freedom are preparing for the Gold Summit. And I’m delighted to be a speaker at this free event.

I hope to see you there.

John Butler
Author, The Golden Revolution