Are we headed for stagflation? If so, how can you prepare for it?

Odds remain low but it's prudent to start weighing up portfolio moves

Are we headed for stagflation? If so, how can you prepare for it?

 Are we heading for economic stagflation in the next 18 months?

Probably not, Jules Boudreau, economist for Mackenzie Investments’ multi-asset strategy team told Wealth Professional, based on his historical readings. While it’s too early to tell which of four scenarios could unfold, including recession, he said advisors should prepare for their next moves. 

“The odds of something like stagflation are low, but the impact on investors if that happened would be pretty large,” he said. “There are things that advisors can do right now.”

Boudreau said there one of four economic scenarios could play out in the next 18 months: 1) an inflationary boom with strong growth and strong inflation, 2) a soft landing with inflation decreasing and growth continuing, 3) a recession, or 4) stagflation, where the economy tanks, but inflation remains high. He thinks the first three are equally likely – with about a 33% chance for each.

“The odds of the stagflation is higher than it was a few years ago, but still low because that transition would need high inflation combined with high unemployment and a shrinking economy, and we’ve only seen that once in modern economic history,” he said. “That was in the 1970s, and many of the things that drove that very unique environment in the 1970s are not really present today.”

Boudreau noted then there were wage price spirals with high cost-of-living adjustments, such as 8%, baked into union contracts. The central banks were also complacent about inflation. Neither of which are happening now. In fact, real wages are lower and the banks, while behind the curve, are aggressively raising rates and reducing their balance sheets to fight inflation.

He said the current environment is more like the 1940s, where the government racked up huge deficits to finance the war and there were persistent supply chain problems after the war. That created strong growth, low unemployment, and high inflation, peaking at 17% in 1948. It only remained high for a couple of years and dropped when the government tightened its budget and supply chains eased.

“It’s very similar to what we’re experiencing right now,” said Boudreau, “and we didn’t get a stagflation in the 1940s with the same environment.”

He’s heartened by that since he thinks a recession, where people could lose their job, but prices decrease, would be better than stagflation, where they could lose jobs while facing higher prices.

“Most fund managers and advisors know how to protect for recession. You use government bonds.,” he said, noting history shows they will rally and help to protect portfolios.

Boudreau expects the inflection point could occur by late summer, so advisors should begin to plan any portfolio changes “upstream before the event happens. You don’t want to be trying to time markets You want to make sure that you have diversification and those alternative exposures before the scenario happens. So, now is as good a time as ever to start looking at those.”

Boudreau recommended not doing big tilts since those could sacrifice returns in the other three scenarios.  Advisors should also avoid having a big build-up of large U.S. stocks because those could be hardest hit with stagflation, and diversify into other markets with commodity exposures, such as the TSX. They should add a small proportion of inflation-protected bonds, gold, commodities, especially energy, but keep those modest as they “tend to have low average returns outside of the stagflation environment.”