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The return of stagflation?

Aspect Capital shares its insights into the potential implications of a stagflationary environment on asset owners’ portfolios and the possible solutions that can be put in place to mitigate its effects.

Summary

The following paper was originally written in October 2019, in response to a client question about the possible impacts of a stagflationary environment on long-term asset owners’ portfolios. At the time, the risk of stagflation seemed a remote possibility. However, the unprecedented fiscal and monetary stimulus provided by central banks and governments in response to the Covid-19 pandemic has prompted a fascinating debate in economic circles, between those who see the sudden and widespread impact on consumption precipitated by the crisis as having a deflationary effect, and those who view inflation as the inevitable result of the unprecedented supply shock and injection of capital into developed economies. Regardless of which side of the inflation debate one takes, the post-pandemic state of the global economy merits consideration. In light of that, we are sharing our insights into the potential implications of a stagflationary environment on asset owners’ portfolios and the possible solutions that can be put in place to mitigate its effects. 

 

Introduction

Some describe central banks as chaperones, whose job it is to take away the punchbowl just as the party gets going. In the clutches of the Covid-19 pandemic, however, the response has been to lace the punch with an unprecedented injection of liquidity and public debt. Consequently, it seems entirely possible that when we emerge from this extraordinary situation we will be confronted by, in Niall Ferguson’s words, ‘An almighty fiscal and monetary hangover ’, in the form of renewed inflationary pressures. At the same time, growth rates have stalled - obstructed initially by trade wars and unstable geopolitics, and more recently (and significantly) by the aggressive social measures taken to contain the pandemic. In light of this, it is not inconceivable that stagflation could make a late entrance and ruin the party for everyone.

 

We define stagflation in a way that is of most relevance to pension plans: the combination of sustained high inflation and prolonged stagnant economic growth, which leads to persistent erosion in the real value of asset owner portfolios.

We utilise data from deep history to understand the nature of stagflation occurrences and their potential impact on traditional portfolios. Furthermore, we study more recent data to make our analysis relevant to today’s world. We demonstrate that a commodity-heavy trend following system combined with multi-asset cross-sectional carry models as well as potential short-term alpha trading strategies can provide a well-rounded solution for traditional portfolios during stagflationary periods. Our solution also has positive expected returns during non-stagflationary periods. Given the low likelihood of stagflation occurring but its impact being profound, such a solution needs to produce useful returns during non-stagflationary periods, which is something that long allocations to commodity markets fail to achieve.

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Unless otherwise specified, this document has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of current regulatory requirements and laws as at the date of publication. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including Colonial First State or any member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. Colonial First State is the issuer of interests in FirstChoice Personal Super, FirstChoice Wholesale Personal Super, FirstChoice Pension, FirstChoice Wholesale Pension, FirstChoice Employer Super offered from the Colonial First State FirstChoice Superannuation Trust ABN 26 458 298 557. It also issues interests in the Rollover & Superannuation Fund (ROSCO) and Personal Pension Plan (PPP) offered from the Colonial First State Rollover & Superannuation Fund ABN 88 854 638 840. Colonial First State also issues other investment products made available under FirstChoice Investments and FirstChoice Wholesale Investments, other than FirstRate Saver, FirstRate Term Deposits and FirstRate Investment Deposits which are products of the Commonwealth Bank of Australia ABN 48 123 123 124, AFS Licence 234945 (the Bank). Colonial First State is a wholly owned subsidiary of the Bank. The Bank and its subsidiaries do not guarantee the performance of FirstChoice products or the repayment of capital from any investments. This document provides information for the adviser only and is not to be handed on to any investor. It does not take into account any person’s individual objectives, financial situation or needs. You should read the relevant Product Disclosure Statement (PDS) before making any recommendations to a client. Clients should read the PDS before making an investment decision and consider talking to a financial adviser. PDSs can be obtained from colonialfirststate.com.au or by calling us on 13 18 36.

 

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