The Implications of Stagflation

Inflation up, economic activity down. It's likely that these five words, which describe stagflation, sum up the worst fears of many investors lately. Even those who don't remember the Seventies have heard the stories of just how bad a time it was. Whenever anyone mentions the word stagflation, the Seventies come to mind so quickly that the two terms can almost be used interchangeably.  Could the coming years also be forever marred in our memories if stagflation strikes again?  We decided to face our fears and see how the market acts during periods of stagflation, if only to understand what we're up against.

Our first step was to define stagflation, but unlike recessions (negative GDP growth) and bull and bear markets (20%+ moves up or down from a trough or a peak), we found no specific definition of stagflation that is generally accepted. Most of the definitions we came across were subjective in nature and described the phenomenon as a period of high inflation and slow economic growth. In the end, we settled on any period of two quarters or more in which y/y CPI was above the overall average since 1948 and y/y GDP growth was below its overall average since 1948. We realize that some may say this approach is too simplistic, but its a starting point at least.

After combing through the data, we found five interesting periods that fit this criteria. First, three of the periods either began or ended in the Seventies, so the fact that so many of us associate stagflation with that decade isn't surprising (and it also means our definition of stagflation is somewhat on the mark). Second, periods of stagflation aren't short. There was no period that lasted only two quarters. In fact, the shortest period was four quarters while the average was eight.

Also noteworthy is the fact that the first occurrence of stagflation didn't occur until 1969 -- over 20 years into our sample series. We also haven't had a period of stagflation (according to our definition) since 1991, which could be a reason why so many of us are fearing it now; If the market can be 'due' for a 10% correction, is the economy 'due' for stagflation?

Many investors believe that the Federal Reserve has refined its policies over time to the point where it can now guide the economy away from these pitfalls. But let's not forget that the economy went through a similar stagflation-free stretch in the Fifties and Sixties, and no one refers to William McChesney Martin (Fed chairman from 1951 to 1970) as a Maestro because of it. We would guess that the truth of the matter is that the economy is a bigger ship than any one individual or government entity can steer.

Now let's get on to what we really care about. How do stocks perform during stagflationary periods? The chart below highlights the S&P 500 performance during each of the periods we identified, as well as the average S&P 500 performance of the five periods. Overall, the returns are mixed, but the average return is roughly 6%.

We can also divide the stagflationary period in half (although keep in mind that in the midst of a stagflationary period we would not be able to identify its halfway point) . As the chart below details, stock performance during the first half of a stagflationary period is generally negative (-11%). Returns were only positive in one of the five periods (1979 - 1981).  Performance in the second half of a stagflationary period is positive, however, as the S&P has risen during each of the five periods for an average gain of 21%.  (Note all returns in this example are unadjusted for inflation).