What Happens to Stocks During Stagflation?

Stagflation is a complex economic challenge combining slow economic expansion with persistent price increases. This environment creates unique pressures on businesses and the stock market, influencing corporate performance and asset valuations.

Understanding Stagflation

Stagflation is an economic condition characterized by sluggish economic growth, high inflation, and elevated unemployment. It defies conventional economic theory, which typically links high inflation with strong growth and recessions with falling prices. The term, a blend of “stagnation” and “inflation,” gained prominence during the 1970s, particularly after the 1973 oil crisis.

Causes often include supply shocks, such as sudden increases in essential commodity prices like oil, which raise production costs. Certain government policies that hinder industrial output while rapidly expanding the money supply can also contribute. This combination creates a difficult policy dilemma, as measures to combat one aspect often worsen another.

Stagflation’s Impact on Business Fundamentals

During stagflation, businesses face a dual challenge that erodes profitability. High inflation increases input costs for raw materials, energy, and labor. This surge in operational expenditures compresses profit margins, as companies struggle to pass on rising costs to consumers without losing sales.

Simultaneously, stagnant economic growth and high unemployment reduce consumer demand and spending. As households grapple with rising costs and uncertain job prospects, discretionary purchases decline, impacting company revenues. This combination of escalating costs and contracting demand squeezes corporate profitability, a primary driver of stock performance. Businesses may experience lower earnings and reduced cash flows.

Consequences for Stock Valuations

The deterioration of business fundamentals during stagflation directly translates into lower stock valuations. As corporate earnings decline and cash flows are constrained, the intrinsic value of a company’s stock often diminishes. This period of reduced profitability makes equities less attractive to investors.

Higher inflation typically prompts central banks to raise interest rates to control rising prices. Elevated interest rates increase the discount rate used in financial models to value future earnings, making those future earnings less valuable in present terms. This adjustment in the discount rate contributes to a downward pressure on stock prices. Furthermore, the general uncertainty and reduced investor confidence that accompany stagflation often lead to a de-rating of price-to-earnings (P/E) multiples, meaning investors are willing to pay less for each dollar of a company’s earnings.

Sectoral Performance in a Stagflationary Environment

Different stock market sectors react distinctly to stagflation. Resilient sectors include those with strong pricing power and providers of essential goods and services. This includes consumer staples, healthcare, and utilities, as demand remains stable. Companies in these sectors can often pass on increased costs, maintaining profit margins.

Commodity-related industries like energy and mining also perform better, especially if stagflation is driven by supply shocks increasing commodity prices. The 1970s stagflation saw energy companies and commodity producers generate strong returns due to soaring oil prices. Vulnerable sectors include consumer discretionary, which relies on consumer spending, and growth stocks, sensitive to higher interest rates. Financials also face challenges as loan demand declines and default risks increase.

Navigating Investment Decisions During Stagflation

When considering investment decisions during stagflation, understanding a company’s fundamental characteristics becomes particularly important. Companies with low debt levels are generally more resilient, as higher interest rates increase the cost of borrowing and can strain highly leveraged businesses. Examining a company’s ability to maintain pricing power for its products or services can indicate its potential to offset rising input costs and preserve profit margins.

Focusing on businesses that provide essential goods and services, rather than discretionary items, can also be a consideration. Such companies often experience more stable demand, making their revenue streams less susceptible to economic downturns. While no investment strategy guarantees success, assessing these attributes can help investors evaluate potential resilience in a stagflationary environment.