Russia’s invasion of Ukraine, among other factors, has increased the risk of “stagflation” – where slowing economic growth combines with accelerating inflation.
Global equities tend to suffer in this environment, as companies combat simultaneous falling revenues and rising costs, which squeezes profit margins.
However, this does not mean all sectors have to suffer. Some stocks will be more insulated than others given their defensive properties and/or positive correlation to inflation.
We think a flexible approach to equity investing can take advantage of these performance differentials and potentially minimise significant losses.
Defensive stocks look like a clear winner
Stagflation tends to favour defensive companies whose products and services are essential to people’s everyday lives. This means their share prices tend to hold up better when the economy slows.
For example, whether inflation is high or not, people still need to purchase food, pay their electricity bills and rent. However, they may prefer to hold off on buying “cyclical” items such as a new car or iPhone until prices are lower.
In quantitative terms, defensive sectors have a market beta of less than 1 (meaning they outperform when the index falls), whereas cyclical sectors have a market beta of greater than 1, (they underperform when the index falls),
This is illustrated in the table below, which displays the average historical return of 11 global economic sectors versus the MSCI World Index in stagflation environments.
The best performing sectors have typically been defensives such as utilities (+16%), consumer staples (14.2%) and real estate (11.8%).
In contrast, cyclicals such as IT (-6.7%), industrials (-3.3%) and financials (-0.5%) have been some of the worst performers.
Unlike their cyclical peers, however, energy stocks (+8.4%) have tended to outperform in stagflation environments.
This makes sense as the revenues of energy stocks are naturally tied to energy prices, a key component of inflation indices. By definition they should perform well when inflation rises.
How do different equity regions stack up?
Based on current sector weights only, the UK and Europe seem to offer the most protection in a stagflation scenario (see chart below).
For example, around 50% of the MSCI UK Index is made up of energy and defensive stocks, while the equivalent figure for Europe is 36%.
Meanwhile, the US and Japan are significantly overweight sectors that would be expected to underperform – such as IT and consumer discretionary respectively (not shown on chart).
However, the UK represents only 4% of the total global equity market capitalisation, so a small overweight may not actually be enough to minimise downside risks.
On the other hand, Europe is a much larger, investable market (11% of the global index) and may therefore offer more leeway to implement a tactical view.
What does this mean for equity investing?
Let’s suppose for a moment that historical returns during stagflation periods were repeated and mapped onto current regional sector weights.
In this scenario, UK and European equities would be expected to outperform a global market-cap weighted portfolio by 4% and 1% per year, respectively.
In contrast, EM equities would underperform by 0.6%, while both the US and Japan would underperform by 0.5%.
Of course, there is no guarantee this would happen and other macroeconomic factors such as the level of interest rates and the strength of the US dollar also play their part.
Nevertheless, tactically adjusting your regional allocation may shield your portfolio if the global economy slips into stagflation.
Investors with the additional flexibility to invest across different sectors and companies – as well as regions – may be even better off.
Authors
Duncan Lamont, CFA
Head of Strategic Research
I am Duncan Lamont, CFA, the Head of Strategic Research, and my expertise lies in the field of investment strategy and market analysis. With a deep understanding of economic dynamics and market trends, I have a proven track record of providing insights that guide investors through various market conditions.
The recent events, notably Russia's invasion of Ukraine, have heightened concerns about stagflation—a situation characterized by slowing economic growth and rising inflation. This scenario poses unique challenges for global equities, as companies grapple with falling revenues and escalating costs, impacting profit margins. However, my expertise allows me to shed light on potential strategies to navigate this complex environment.
One key observation is the differential impact on various sectors during stagflation. Defensive stocks emerge as winners, given their essential nature in people's daily lives. Regardless of high inflation, necessities like food, utilities, and real estate remain crucial, making defensive stocks resilient. Quantitatively, defensive sectors, with a market beta of less than 1, tend to outperform when the index falls, while cyclical sectors, with a market beta greater than 1, underperform in such conditions.
Historical data supports this, showing that defensive sectors such as utilities, consumer staples, and real estate have outperformed during stagflation, while cyclical sectors like IT, industrials, and financials have struggled. Notably, energy stocks have performed well in stagflation due to their natural tie to energy prices, a key component of inflation indices.
Examining equity regions, the UK and Europe appear more resilient in a stagflation scenario, with significant weights in defensive and energy sectors. The US and Japan, however, are overweight in sectors expected to underperform, such as IT and consumer discretionary. Tactical regional allocation becomes crucial, and while the UK is only 4% of the global equity market, Europe's larger size (11% of the global index) offers more room to implement a strategic view.
In terms of potential returns, a scenario analysis suggests that, if historical patterns hold, UK and European equities may outperform a global market-cap weighted portfolio during stagflation. Emerging market equities may underperform, while the US and Japan could also see underperformance. However, it's essential to note that these projections come with uncertainties, considering other macroeconomic factors like interest rates and the US dollar's strength.
In conclusion, a flexible approach to equity investing, incorporating sector and regional adjustments, can potentially mitigate losses during stagflation. Investors with the flexibility to navigate different sectors, companies, and regions may find themselves better positioned in the face of global economic challenges.
