If any of you are followers of the ‘Ruminations of Ruby the Cat’, you will realise that I have recently been exercised by the possibility of the UK, or indeed the world economies, suffering in the near future from stagnation. Before explaining the concept of stagflation and how it might affect the performance of your pension and personal investments, I would like to address a misunderstanding which I frequently encounter: a failure by the investor to understand the link between economic and investment performance.
For example, if an economy has low inflation and good growth, the funds investing in that country will be performing well. Equally, if inflation is high and growth low, the performance will be minimal. This poor performance is not the fault of the fund manager, but merely a mirror of the economic situation in that country. This is why equities and, increasingly, fixed interest holdings such as government bonds, Gilts and US Treasuries are best viewed as long-term investments. There will be frequent volatility, but history shows that for the long-term investor there is a gain in excess of holding cash.
You may have read recently that commentators are reflecting on the possibility of the world economies falling into a period of stagflation. We all understand the concept of inflation, and even deflation, but for many people the prospect of living through stagflation is something they have never considered. The last period of stagflation occurred in the 1970s, when in 1973 OPEC sharply raised oil prices after the Arab-Israeli war, and again when oil prices rose in 1979 after the Iranian Revolution. In this period, inflation increased quickly because of the surge in the price of energy, which inevitably resulted in increases in the cost of living and employees demanding higher salaries to keep pace with these rising costs. In turn, employers needed to increase the price of their goods or services to cover these increased wage costs, which fuelled the inflation rise. Here in the UK, inflation peaked around August 1975 at a figure of approximately 27%.
Could this happen now? It is likely, and therefore it is important to be prepared. I would suggest that the situation is similar to discovering that you may have an illness. There is a period of uncertainty, then you consult the doctor (this may take a differing length of time). The disease is identified, the symptoms explained to you and medication prescribed. The reality of knowing the prognosis, the symptoms and the likely period of recovery makes you feel back in control and able to deal with the problem.
Let’s look at stagflation using the same model. I have highlighted the symptoms in the previous paragraph; what then is the timescale? This is the bad news: it is not brief. The period in the 1970s in the USA and UK lasted for the best part of a decade and was only curbed by the introduction of tight monetary policy.
How can you prepare? The first and most important piece of advice is acceptance, and not to be blinded by figures, large or small. What do I mean by this? The central banks are likely to increase interest rates to curb inflation. The higher interest rates may lure investors to move from equities to cash, but this may be a false move. The figure which is important is not the interest rate itself, but the difference between the interest rate and the then current rate of inflation. It is unlikely that the interest rate will keep pace with inflation, whereas the returns from equities superficially may not look enticing, but the real return in most cases will be keeping pace with inflation. The returns from equity portfolios will be lower, but history shows that remaining invested in equities is the correct long-term strategy.
We are aware that our clients need to be prepared. There are actions we will be taking once there is an indication of resolution and stability in the Middle East. We will be reviewing portfolios and recommending a gradual reduction in holdings where the asset content is weighted to countries reliant on the importation of energy, and favouring funds where the manager is weighting holdings to utilities, consumer staples and healthcare, with less emphasis on consumer discretionary stocks, IT and financials. This will be a gradual process, because we anticipate continued stock market volatility.
Our final message to the reader is that an investment plan is in place to fulfil long-term objectives, and we as advisers are here for the long term to help our clients through inflation, deflation and maybe this time stagflation.