Stagflation: Every Government's Worst Nightmare

Are you concerned about the economy? You should be. Inflation is at a 40-year high, and there's no telling how long it will stay. The financial markets are unstable, and the amount of people struggling to make ends meet grows. Unemployment rates are skewed, and it seems like things will only worsen. This might sound like a bleak picture, but it's the reality we're currently facing. So what can you do to prepare for these difficult times?

The Concept of Stagflation

The word stagflation refers to a situation of stagnant demand (or stunted economic growth) and high inflation. The first signs of stagflation you might notice in an economy would be high-interest rates, decreasing gross domestic product (GDP), growing unemployment rate, all coupled with inflated prices of goods and services - making it difficult for both individuals and businesses to retain the value of their money.

The concept of stagflation is unnatural because it depicts a direct correlation between inflation and a weak economy (usually, where there is a weak economy, the chances of inflation are minuscule). Still, even economists are often left in the dark where these two meet. How did stagflation come to be?

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Historical Perspective on Stagflation

In the USA and the world, past economists were familiar with inflation but could not wrap their heads around stagflation. The reason for this is simple; the economic models that existed back then saw an inverse relationship between unemployment and inflation and could not believe both could coexist harmoniously. A growing economy, which often precludes inflation, causes the demand for goods and services to grow. More workers will be needed to produce these extra demands, thus causing a decrease in unemployment.

The stagflation came to be by these models being disrupted. In the early 1970s, the United States economy went through a rough patch. Despite constant inflation, economic growth appeared to be stunted.

Source: Business Insider

Between 1973 and 1975, the United States suffered a recession-like economy, with five quarters of negative GDP. As if it wasn't bad enough, unemployment peaked at 9% in 1975, while inflation lingered in double digits during 1974 and 1975.

You could wonder what prompted this. Many things happened, but the embargo imposed by OPEC on the United States in 1973 was the tipping point. The price of oil rose as supply fell. While the OPEC embargo is widely credited with causing the 1974 stagflation, it would not have been feasible without the policies put in place by the US administration just before the OPEC embargo.

What policies are we talking about? When President Nixon ran for reelection in 1970, he promised a three-pronged economic plan to resurrect the economy. During this time, the economy was in negative territory, and the unemployment rate was at 6%. The policies he enacted, known as the Nixon shock, were designed to boost the economy without causing inflation.

The Nixon Shock

Nixon's policies introduced three important changes.

  1. To tackle inflation, the President took severe steps, one of which was to freeze wages and prices for 90 days. During that time, there could be no pay or price increases. After that period had passed without any raises or cost-of-living adjustments, a Pay Board and Price Commission, set up for that purpose, would authorize any increases until after the elections were held.
  2. The administration of President Nixon imposed a 10% tax on imported goods to protect domestic industries and lower trade deficits. Instead, the measures backfired, and prices for these products rose by an average annual rate of over 5%.
  3. He suspended the Bretton Woods Agreement and removed America from its gold standard.

Removing America from the gold standard was a pretty unbelievable strategy. The gold standard was what made the dollar the global currency, and Nixon would have gotten away with these policies except for the UK's request to exchange $3 billion for gold. There wasn't that much worth of gold in the USA, so Nixon stopped backing dollars against gold - sounds like a default, no? Basic economic principles set in, and the price of gold shot up as the dollar lost its value.

Source: Bullion Vault

It became more expensive for US citizens to import goods, and with unemployment not reducing, the result was one of the biggest economic chaos ever faced in the country. The lesson economists learnt after 1975 was that inflation can strike anytime, even while the economy is slowing down.

Stagflation vs Inflation

There is a significant distinction between inflation and stagflation. The former refers to an increase in the price of goods and services and is usually seen in a growing economy where the demand exceeds the supply. The latter, stagflation, is when inflation happens in a poorer economy riddled with high unemployment and lowering gross domestic product.

Also, on the part of manufacturers, the difference between inflation and deflation is enourmous. In an inflated economy, businesses have steady profits because consumers' purchasing power is high. The same cannot be said for a stagflation economy that is characterized by high prices of goods and labour, but lesser sales due to lower purchasing power from consumers.

How to Hedge Stagflation

Solving stagflation is usually a real concern to the government (that, of course, causes it in the first place). The solutions to unemployment further aggravate the inflation rate and vice versa. While it is quite difficult to solve, it is not impossible to hedge. One important way to hedge against it is to invest in stronger assets than some of the falling fiat currencies. These assets include:

1. Cryptocurrencies

Cryptos have been called different names by different individuals. While the argument still exists on its role in our financial system, stagflation could bring its importance to a unanimous conclusion. Stagflation is an economic issue triggered by extensive central banks monetary policies combined with other (often populist) political decisions, and with cryptocurrencies like BTC or ETH being market-driven and transparent, one would expect that cryptocurrencies will have one up on the dollar when the stagflation crisis hits.

2. Overperforming fiat

While it might be counterintuitive to invest in currencies issued by governments directly responsible for this mayhem, if you get a sense that the stagflation situation in US will be better than in Europe, given the war madness and all it brings to the old continent, you could go long USD against EUR & GBP.

3. Commodities

At the time when the economy is in shambles, commodities tend to act as a hedge. Metals such as gold are known to cushion any shock from stagflation--and even if you don't plan on selling them for a while, they can still serve their function of preserving wealth. During the covid period, when alcohol-based sanitizers, nose masks, and toilet papers became a hot cake, commodities like gold, metals, and even agricultural products soared too.

4. Credit

With the interest hikes aimed at curbing growing inflation, there is a change of fortunes for lenders who decide to provide liquidity to the markets. Pushed to invest in riskier assets such as lower quality commercial papers to generate lucrative yields, lenders will be able to pocket more lucrative earnings even on higher grade bonds. Still, with inflation raging, one should be careful not to end up net-negative.

Is There a Chance We Will See Stagflation Again?

Over the years, analysts and regulators have dreaded the S-word. The fear was at its highest after the 2008 housing crisis; coincidentally, the same occurrence signaled the birth of the new wave of financial wealth; cryptocurrencies. In fact, this year has seen the greatest fears of stagflation in financial circles since 2008. To be frank, those fears seem quite justified, with what is happening in the United States and around the world.

Source: Bank of America

While it is true we won't see another removal from the gold standard, and the supply shock from the control of wages and prices doesn’t seem likely as those policies are seen as archaic, several factors point to a repeat of the 1970s. For the US, the inflation rate is almost at 8% now (the highest it has been in 40 years), and it has become clear that printing money at will has its own consequences. Its economy is also facing its highest uncertainty in a long time. While this is bad enough, it is mild compared to how Europe as a continent is faring. Weaker prospects of growth, rising gas prices, and increased volatility in interest rates is bringing many to the conclusion that stagflation might be inevitable. Hopefully, we will return to normalcy soon, but to stay safe, ensure you hedge your capital. No one goes wrong with hedging.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.