Stagflation or deflation?

Over the past two years, the world witnessed one of the fastest bear markets and the quickest subsequent recovery, thanks to the pandemic. Now, rising inflation and slow global economic growth have led to deliberations between experts about what will come next – deflation or stagflation?

Both are likely and will have a material impact, which investors will need to plan for.

Globally, we have seen central banks aggressively raise interest to bring inflation down. This has given rise to the possibility of not only lower economic growth, but also potential recession – particularly in the United States (US).

A slowdown in economic growth ultimately results in gross domestic product (GDP) numbers decreasing, with corporate earnings normally following suit. These factors can affect equity prices, leading to the printing of lower inflation numbers.

Stagflation is generally categorised as low growth combined with high inflation, an environment that usually leads to lower corporate earnings. This is much more difficult to navigate for central banks and a key concern for markets at the moment.

There currently isn’t much talk about deflation in the market. For example, consider the inflation outlook for the United Kingdom (UK), where inflation rates of between 17% and 22% are currently forecasted. Everybody is trying to manage the inflation shock that’s anticipated.

The reality is that the higher inflation climbs, the higher the likelihood of subsequent deflation because you’re creating a very high base effect in the numbers.

Statistically, after periods of high inflation, there is an increased probability of deflation. The question is, will this deflation be short-lived or sustained?

I believe deflation will be short-lived, given that pricing pressures mean that prices will remain higher for longer.

If you look at some of the key drivers of inflation, like oil or energy prices, these might recede over the short-term given how hard they have run in recent months. However, a lack of investment in this sector puts a structural tailwind behind the prices.

This results in a possible scenario that sees a high base moving lower and then a brief period of deflation, followed by a longer period of stagflation. It is essential that this potential scenario is accommodated in your investment strategy.

In this environment, sound financial advice has never been more important as investors seek asset classes that will help shield their savings from inflation and protect the real value of their money. This becomes increasingly difficult as inflation and interest rates rise.

In terms of your investment strategy and given the looming stagflationary environment, investors should focus on businesses that can protect their margins.

The key is not to overpay for assets or securities. We invest in businesses where many of the risks have been priced in, which allows for some leeway to surprise on the upside.

This environment also has a material impact on the unit trust industry and the various inflation-linked benchmarks used. For example, an inflation-plus-3% benchmark is now north of a 10% return. Interest rates are moving higher to combat inflation and as they rise, asset classes fall under pressure.

It’s important to be aware that the investment horizon of products may be three or four years, but the prevailing interest rate and inflation cycles are much longer than that.

Investors are going to have to adjust their expectations to ensure that they interpret the performance of their products accurately.

To ensure the best possible outcomes, engage experts who will provide sound guidance and help you navigate the various scenarios.

Adriaan Pask is chief investment officer at PSG Wealth.