Re-published with permission from the Financial Times, the original article can be found here.
A different world looms from the one that has buoyed most portfolios in recent decades
The writer is co-chief investment officer for Bridgewater Associates
It’s been awhile since investors faced a stagflationary environment and there are good odds that this is what they will face over the coming decade.
In stagflation, a high level of nominal spending growth cannot be met by the quantity of goods produced, resulting in above-target inflation. Policymakers are not able to simultaneously achieve their inflation and growth targets, forcing them to choose between the two.
This choice is acutely difficult in Europe due to the simultaneous weakening in economies: nominal spending is being absorbed by higher energy prices, leaving less real growth, while the decline in the euro is raising the cost of imports.
It is being made more difficult in the US by the stubbornly high inflation reports, which persist despite the first round of monetary policy tightening. And there are now early indications that the tightening is beginning to slow growth, perhaps leading to an economic downturn.
To understand the investment implications of stagflation, investors must recognise that all assets have biases with respect to economic growth and inflation, either benefiting from or being disadvantaged by each of those forces. It is the net of those relationships to growth and inflation that then determines how an asset would perform.
Historically, equities have been the worst-performing asset in stagflationary periods, because they are vulnerable to both falling growth and rising inflation.
Other predominantly growth-sensitive assets like credit and real estate also perform poorly. Nominal bonds are closer to flat in such environments. This reflects the cross-cutting influences of falling growth that typically leads to easing and falling rates, weighed against rising inflation expectations which usually put pressure on rates to rise. As rates increase generally, the yields on existing bonds can appear less attractive, pushing prices down.
Inflation-linked bonds and gold perform the best, with the former benefiting from both weak growth and rising inflation.
How central banks respond is another major determinant of how a stagflationary environment plays out — do they aggressively tighten to contain the inflation and exacerbate the growth problems, or do they remain accommodative to support growth and hope the inflation doesn’t become entrenched?
Those decisions directly impact key inputs into the valuation of assets such as discount rates and risk premiums. The former is the rate at which future returns are discounted for time, usually a sovereign bond yield such as US Treasuries. The latter is the extra return demanded by investors for taking on risk.
Generally, assets will still perform well if there is only a moderate degree of monetary policy tightening and risk premiums are falling. They will perform particularly poorly if there is a major tightening and risk premiums rise.
Within these monetary policy regimes, the relative returns of assets still align with their biases, with index-linked bonds, gold, and commodities giving investors better relative returns regardless of how policymakers respond.
But regardless of how the pressures net out across asset classes, most investors would face considerable vulnerabilities in stagflation.
To help mitigate this, the most effective moves most investors could make are to shift away from vulnerable equity and equity-like exposure. Take for example, shifting some risk exposure from equities into index-linked bonds — whether accomplished by changing one’s asset allocation or hedging with a derivative of some kind if an investor has access to this.
The effect of this can be shown in the Sharpe ratio, a commonly used measure in markets of return against a risk-free benchmark that is adjusted for volatility. Any Sharpe ratio above 1.0 is considered positive.
In stagflationary environments, a portfolio shift into index linked bonds from equities has a Sharpe ratio greater than 1.0. In contrast, equities have ratio of -0.72. And the portfolio commonly held by investors of 60 per cent equities, 40 per cent bonds has one of -0.70.
Similar benefits could be seen in a shift from equities to gold, or from nominal bonds into index-linked bonds. Such diversification tends to make portfolios more resilient over time but are particularly critical when considering the risks today.
There are a variety of ways that stagflation can play out, and any new environment will bring its own unique challenges. But understanding the biases of assets to growth and inflation is a powerful starting point for investors considering how to prepare for a very different world from the one that has buoyed most portfolios in recent decades.