Robert Steinadler, a year ago

Stagflation: The poisonous effect on the economy explained

Stagflation might be a term that you’ve already come across if you are into economic and financial news. The term describes a situation where stagnation of the economy meets high inflation. This situation occurs when inflation and unemployment rates are very high at the same time, both slowing down the growth of the economy.

Such a situation where stagflation occurs can have a devastating impact on the economy and lead ultimately to a dilemma. Central banks usually would like to fight inflation by increasing interest rates or quantitative tightening. Both measures have been taken by the Fed in the US in 2022 and to some extent by other countries and their respective central banking system.

The downside of these moves during stagflation is that both measures are stressing the economy further. This makes it very hard for all institutions involved to fight inflation. On the one hand, they cannot allow inflation to increase, on the other hand, they have a hard time fighting it because it will hurt the economy.

What are the reasons for stagflation?

The reason for stagflation is usually a supply shock and an increase in energy prices. Higher energy prices increase the costs of production. This usually means that businesses will reduce production and increase prices. If the demand for their goods stays the same the prices will necessarily rise. Another effect is that with less production, fewer jobs are created and more workers are being laid off. Therefore, the unemployment rate is rising and people will have less money to spend and create less demand.

This creates a spiral. With more unemployment, higher costs, and less production, the demand shrinks further and therefore businesses have to shrink. With rising inflation, businesses and consumers are both trapped.

One way to mitigate stagflation is to reduce energy prices and take away the pressure from the businesses another one is to break inflation expectations. With the war in Ukraine and the sanctions on Russia in place while at the same time facing record-breaking inflation chances are high that we are going to risk stagflation in our economy.

What are the effects of stagflation?

The characteristic of stagflation is decreased economic growth, while inflation and unemployment are on the rise. Should the inflation rise further there is also the risk of a wage-price spiral. This means that workers will ask for higher wages to keep up with the inflation and to cover their increased expenses.

This can lead eventually to even more pressure on the overall situation. Prices have to be increased further because businesses have to compensate for the increased expenses that they have to pay for the labor costs.

Another possible effect is more volatility in the stock market because investors are losing their trust. Needless to say, historically speaking it takes a very long time for an economy to overcome the effects of stagflation and recover from it.

Which investments are solid during stagflation?

As we already have explored stagflation is very difficult to handle for an economy and for central banks. We cannot make a forecast about how certain assets will behave during such a situation, but what we do have is historical data that shows how assets performed during past times were stagflation occurred.

Please take into account that history doesn’t have to repeat and that the assets that we are discussing in this article might perform differently.

Gold was the winner in the 70s

During the oil crisis in the 70s, stagflation occurred. What also happened is that the gold price doubled between 1973 and 1974. In 1979 the price even increased by 115% within 12 months. This indicates that gold could possibly be a good choice during such hard and uncertain times.

Cash is king, or is it?

Cash has a less protective effect on investors since stagflation will come with higher inflation. With purchasing power melting away, cash is probably not attractive as an investment. On the other hand, cash can protect investors from banks going bankrupt since they are holding their money right in their hands.

Stocks facing volatility

Stocks are usually performing well during the upstart of stagflation. On the other hand, there won’t be high gains on stocks with the economy going down the drain. This means that if we take inflation into account all gains in stock price might be zero or lower.

The performance of a stock portfolio might differ since each portfolio is built differently. Therefore, it is difficult to make general statements about the overall performance of stocks.

Bonds are under pressure

With a shrinking economy and a rising interest rate, bonds usually face a difficult time. During stagflation, businesses tend to have a less attractive credit rating while at the same time being under pressure by inflation like everybody else. The longer the stagflation lasts the more bonds come under pressure.

Cryptocurrencies - A new dawn?

During the last three years or so Bitcoin has been discussed as digital gold since it is ultimately scarce. But there are also alternatives that don’t rely on scarcity but create yield and passive incoming. Such is possible with staking, lending, and yield farming.

There is no historical data available on how cryptocurrencies as an asset class will behave. Therefore, we cannot come to any conclusion about their performance. Still, with traditional assets coming under pressure there might be a chance that investors will try to turn to alternatives that promise either unmatched scarcity as in Bitcoin or additional cash flow through DeFi or staking.

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