History suggests that in an environment of low growth and high inflation, stocks may not perform as poorly as investors fear. In the following analysis, Duncan Lamont, Head of Strategic Research at Schroders, has shared his insights and data that can help advisers and investors navigate a concerning economic environment like we have right now.
Fears are rising that the global economy could be heading in a stagflationary direction –- one where economic growth is weak and inflation high. Increasing tensions in the Middle East and the risk of rising energy prices only adds to these worries. On average, this is the worst kind of environment for the stock market. But investors need not panic. Our analysis shows that stocks often perform well when there is stagflation, just not as well as at other times.
Importantly, there has been divergence in sector performance in these environments and performance between companies is likely to rise, too. There is an argument that the sector allocation of European stock markets could benefit them relative to the US. This would be problematic for many investors, given that the US dominates the global market.
As well as the well-trodden valuation argument, this is one more reason why we believe investors should be wary of passive approaches to investing in global equities today.
Why does stagflation present a challenge for companies and investors?
Low growth is bad for sales, as businesses and consumers tighten their belts. Demand is weak. High inflation adds to the headache. In a buoyant economy, companies can pass on higher input costs to consumers. When demand is already weak, this isn’t so easy. Corporate profit margins often take a hit instead, putting additional downward pressure on earnings.
As well as weakening corporate fundamentals, the ability of central banks to stimulate demand by cutting interest rates is also hampered. When inflation is high, they typically want higher interest rates to bring inflation under control, not lower. And higher rates risk making the “stagnation” worse. But if they were to cut rates, that risks sending inflation even higher. There are no easy options.
How do stocks perform during stagflation?
In this analysis, we have defined stagflation fairly simplistically: real gross domestic product (GDP) growth below the previous 10-year average and Consumer Price Index (CPI) inflation above its 10-year average. By keeping things simple, we can analyse market performance over the past nearly 100 years. When it comes to analysing sectoral performance, we cover the period since 1974.
We compare using 10-year averages rather than fixed rates of growth and inflation because what will have felt like low growth or high inflation to investors isn’t constant over time. It depends on what they will have been used to. This is a less severe definition of stagflation than those that require there to have been a recession (negative growth).
As could be anticipated for the environment described above, stocks often find the going tougher during stagflation years compared with other environments. Based on data since 1926, the median yearly real return in a stagflation year has been about 0%. This is less than investors would typically want from equities over the long-run, but it still means returns have been in line with inflation. In addition, in about half of these years they generated a positive real return – and, when these real returns have been positive, they have tended to be strong, averaging about 16%. In the interests of balance, it is worth pointing out that when they were negative, they averaged -14%.
Figure 1: Equities perform well in around half of stagflationary environments, worse than others but should not be ruled out
US real equity returns when inflation and growth are above/below their 10-year average, 1926-2024 calendar year data (number of occurrences in brackets)
Past performance is not a guide to the future and may not be repeated.
HighInfl = inflation above the previous 10-year average, HighGrowth = real GDP above the 10-year average, and vice-versa for LowInfl and LowGrowth. Based on analysis of data on US equities 1926-2024. Because the first 10 years are used to calculate the first 10-year averages, this leads to 89 years when an assessment of the economic status is made. Source: Stocks represented by Ibbotson® SBBI® US Large-Cap Stocks, Cash by Ibbotson® US (30-day) Treasury Bills. Data to December 2024. Morningstar Direct, accessed via CFA Institute and Schroders.
When assessed relative to cash, equities come out better, outperforming cash more often than not (in 10 of the 17 stagflation-years). This may be a riskier than normal time for stocks, but it can also be a risky time to sit in cash.
Furthermore, statistical analysis of how stocks have performed relative to cash in stagflation-years compared with the rest of the time indicates there is no significant (in a statistical sense) difference. In other words, any difference could be due to random noise rather than a meaningful relationship.
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