Stagflation redux?

Strange times are these in which we live. A naval blockade, an uneasy ceasefire brokered by an unpredictable president, and oil still uncomfortably close to $100/bbl. And how have stock markets fared in such testing circumstances? Global equities are back at fresh highs, and the Nasdaq has just notched its longest winning streak (12-days) since 2009. It seems merely the absence of bad news is enough to push stocks higher.

Meanwhile, we are left grappling with the economic fallout from the enduring closure of the Strait of Hormuz, which is now well into its 7th week. The immediate macro impact of the conflict is clear: more inflation, and less growth. The inflation comes from squeezed energy and commodity markets; the threat to growth comes from those higher energy costs, the disruptions, and from the likely impact on consumer and business confidence.

The prospect of (even) more inflation alongside deteriorating growth prospects is prompting talk of stagflation (output “stagnation” + price “inflation”). Such an outlook is perhaps the most difficult combination conventional portfolios can face. March was a case in point: stocks and bonds fell in tandem. The poor economic growth environment is bad for corporate profitability and stocks, while high inflation is bad for bonds (and, if it keeps interest rates higher, for stocks too) and other nominal assets – there is no obvious hiding place.

The potential parallels now with 1973 and 2022 are clear – in both crises, inflation was amplified by war and oil prices, and growth suffered. However, the starting point and the context are quite different today.

In the early 1970s-episode, inflation was already rising in response to the earlier Nixon shock and widespread labour disputes. The onset of the Yom Kippur War and the ensuring 1973 oil embargo delivered a much more dramatic energy shock – both in terms of scale and longevity. A bigger reliance on oil as the primary energy source and a dependency on OPEC output left many countries in a vulnerable position. Oil prices tripled over a period of less than a year and ended the decade tenfold higher - intensified by recurrent crises along the way.

What followed was a very challenging macro climate. In the decade ending 1983, average annual US GDP growth halved, to 2%, while average inflation doubled, to 8% (average UK GDP growth fell by two-thirds, to just 1%, while average inflation more than doubled, accelerating from 6% to 14%). It was no less comfortable for investors, with both bonds and stocks often falling well behind inflation (the troubled macro picture was not just a reflection of higher energy costs: much of the stagflation was likely reflecting a deeper malaise, the cumulative effect of years of poor industrial relations and misguided macro policies).

Russia’s invasion of Ukraine was no less unsettling: it marked the first major threat to European peace since 1945, and continues to exact an awful human cost today. The economic consequences were largely inflationary, with a relatively modest hit to output, but again the damage came at a time when inflation had also been building beforehand (European headline inflation had risen to 6% by the time Russia invaded) as a result of pandemic bottlenecks, and excessively lax fiscal and (for a while) monetary policy.

The energy shock in 2022 – which amplified those broadening price pressures – was also more dramatic than today’s surge. Oil prices broadly doubled over six months, but infrastructure-constrained natural gas briefly went exponential (over a tenfold increase at one point), before quickly retreating. Ultimately, the difficult combination of sharply rising interest rates and high inflation prompted both stocks and bonds to fall by a fifth through 2022 – the worst ‘real’ return for a ’60:40’ balanced portfolio in nearly a century.

In contrast, today’s weakening growth prospects and/or rising inflation may prove both more modest in scale and relatively short-lived: the episode is too young to warrant talk of a new investment regime. The original 1970s stagflation was a long time in the making – it didn’t arrive (as today’s headlines have) almost overnight.
Going into this episode, economic growth had been reviving – early post-conflict survey data was remarkably resilient – and inflation appeared manageable. Oil and natural gas prices today are undoubtedly elevated – some refined products for imminent delivery even more so – which will inevitably push inflation higher in the near-term. We also know that there will be higher indirect inflation through food prices and rising input costs for businesses. But those prices have not yet risen on the sort of scale that roiled the economy in 2022, let alone the 1970s. Meanwhile, unlike 2021/2022, interest rates – and bond yields – are significantly higher, and closer to what we might consider as neutral (or ‘fair value’).

It is too soon, we think, to consider a bigger, wholesale shift into the sorts of real assets – property, commodities – that offer more intuitive protection if stagflation were to take root. It is important to note that over short time horizons, real assets don’t always neatly protect: inflation-linked bonds have generally performed well this year, but they didn’t for much of 2022; meanwhile, gold’s retreat reminds us that its hedging role (whether against risk assets or inflation) cannot always be relied upon.

As for the remarkable rebound in risk assets, there has been a pivot back towards ‘growth’ segments and AI-linked stocks – an echo of 2025. If the macro damage is contained and the hawkish repricing in interest rate expectations doesn’t materialise, then renewed investor optimism may not be wholly inconsistent with the troubling geopolitical story. First-quarter earnings are growing briskly and expectations for 2026 continue to build (in turn, restoring some headroom to forward valuations). If that story persists, stocks may continue to look across the valley.

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