What Is Stagflation?

·5 min read

Today's economy has some of the telltale signs of stagflation: It's experiencing supply chain shocks, ongoing elevated inflation, rising energy prices and lower economic growth forecasts.

Stagflation describes an economic scenario of stagnant growth paired with high inflation. In the late 1970s, the U.S. economy experienced severe stagflation. There was a mix of high levels of inflation, high unemployment and rising oil prices. This economic weakness ultimately led to two economic recessions.

Although it may appear that stagflation threats are again present, the U.S. economy has some bright spots. It has seen rising consumer demand, recovering unemployment and increasing wages. So should investors prepare for stagflation, or are analysts mischaracterizing today's economy? Here's what you need to know about stagflation and whether the U.S. economy is threatened by it:

-- What is stagflation?

-- Is the economy headed toward stagflation?

-- How can investors protect against stagflation?

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What Is Stagflation?

Stagflation describes slowing economic growth combined with high unemployment and inflation.

One of the causes and apparent consequences of stagflation is the rise in the price of commodities, particularly oil. Since oil is such a widely used commodity, a price increase results in higher costs for businesses when producing goods or services associated with it. Some of these higher costs are inevitably passed on to the consumer.

Stagflation is also associated with lower economic output and productivity. Higher prices of raw materials result in higher costs for businesses. This may impact a company's profitability and can result in slower economic growth. In this scenario, businesses may cut costs by laying off employees, leading to an increase in unemployment. Lower unemployment rates tend to be correlated with higher levels of inflation. But during stagflation, unemployment and inflation are both high.

An economy in stagflation presents challenges for governments and monetary authorities to find targeted solutions that address its myriad problems simultaneously. U.S. monetary policy typically does not provide the solutions to supply shocks, unemployment and inflation, which makes getting out of stagflation difficult. One way to reduce inflation is to raise interest rates or cut spending, but both could lead to further unemployment.

[READ: Stock Market Outlook for Q4 2021.]

Is the Economy Headed Toward Stagflation?

A version of these characteristics seems present in the U.S. economy today, including the elevated inflation, which may have investors wondering whether the economy is heading toward stagflation. But some experts say that is far from the case.

"In order to experience stagnation, we'd need to see high unemployment, increased taxes and slowing growth -- none of which are currently present, but certainly could be in the not-too-distant future," says Bryan Cannon, CEO and chief portfolio strategist at Cannon Advisors.

But stagflation may be possible in the long term. Stagflation in the U.S. economy is "not unlikely" in the future, says Mariano Torras, professor of finance and economics at Adelphi University. "The U.S. economy is in the midst of a long-term stagnation, but I'll allow that this is not clear from some of the traditional short-term indicators like the unemployment rate," he says.

When looking at the stagflation that took place in the 1970s, experts say it was spurred by the fact that the economy was more dependent on commodities. Today, however, the economy is experiencing supply chain disruptions, robust consumer activity and high levels of inflation. This is not a recipe for stagflation in the short term.

"The inflation (today) is caused by a strong economy, not by a pervasive commodity shock, and consumer activity, plus still-high excess savings, indicating hearty growth over the next few quarters," says Dan North, senior economist at global trade credit insurer Euler Hermes.

In order to experience stagflation, Cannon says, the economy would need to experience a prolonged, sharp slowdown in growth, and that is not yet the case in today's economy. GDP growth slowed from a 6.7% annual pace in the second quarter of 2021 to just 2% in the third quarter, prompting a lot of talk about stagflation. Goldman Sachs recently lowered its forecast for 2022 growth, but at 4%, it is still indicates a robustly growing economy.

"We are in the midst of a long-term secular bull market, which historically lasts 17 years on average, and the sample size is small -- we are only eight-and-a-half years into the current secular bull market," Cannon says.

[SEE: 8 Growth Stocks to Buy at Attractive Prices.]

How Can Investors Protect Against Stagflation?

Whether you believe the economy is approaching stagflation in the short term or long term, several investing strategies can address this economic risk.

Experts say Treasury inflation-protected securities, which are bonds that offer protection against inflation, are good hedges again stagflation since they benefit from rising prices. Commodities like oil, precious metals and agricultural goods are another asset class that could help mitigate the risks of stagflation.

"Stagflation is hard to protect against because neither bonds nor stocks are likely to do in an environment where prices are rising but the economy is weak," says Andy Kapyrin, partner and co-chief investment officer at RegentAtlantic Capital.

But it's not impossible, experts say. Another way for investors to protect against stagflation in their investment portfolios is to invest in companies that are able to weather the rising expenses accompanied by inflation. Companies that can maintain profitability or increase their profit margins are strong considerations.

"Invest in companies that can consistently pass along price increases caused by inflation, as this allows them to maintain margins," says Steven Saunders, director and portfolio advisor at Round Table Wealth Management.

Saunders says some of these investments may include commodity-linked equities, like oil, gas or gold-mining publicly traded companies, or large tech firms with critical software and infrastructure with unique and irreplaceable assets.

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