Nowhere to hide from the ravages of stagflation
Faced with the growing geopolitical tensions between Washington and Beijing, and the frustrating supply disruptions caused by the coronavirus pandemic, an increasing number of Western companies are looking to onshore, or nearshore, their production facilities.
According to a report in The Wall Street Journal, Apple has told some of its contract manufacturers that it wants to boost production outside of China, partly because of Beijing’s strict COVID-zero stance.
Race to onshore manufacturing
Analysts estimate that more than 90 per cent of Apple products such as iPhones, iPads and MacBook laptops are manufactured in China by outside contractors.
But the move by Western companies to make their supply chains more resilient represents a huge shift from the thinking that has dominated the past few decades, where the aim of most companies was to produce goods at the lowest possible cost.
Germany’s central bank boss, Joachim Nagel, last week warned that deglobalisation was one of the “three Ds” that would “add to inflationary pressures” alongside decarbonisation and demographics.
He added the shift away from globalisation was being “fuelled by geopolitical tensions and the desire to reduce economic dependencies”.
Meanwhile, Ben Bernanke, the former head of the US Federal Reserve, has warned that for the first time since the 1970s, the US economy could be headed for a period of stagflation.
“Even under the benign scenario, we should have a slowing economy,” he told The New York Times. “And inflation’s still too high, but coming down.
“So, there should be a period in the next year or two where growth is low, unemployment is at least up a little bit, and inflation is still high. So you could call that stagflation.”
But if Bernanke is correct and the global economy is heading for a period when inflation remains uncomfortably high – even though economic activity is tepid – investors face an uncomfortable period ahead.
Because the grim reality is that in periods of stagflation, there are no safe havens.
Equity markets are extremely vulnerable as central banks are forced to raise rates to tame inflation.
Already, the prospect of higher interest rates has sent the S&P 500 benchmark of blue chip US stocks tumbling by 19 per cent this year, while the tech-heavy Nasdaq has fallen by 27 per cent.
But analysts warn that shares could fall even further, as more companies find their profit margins squeezed by rising costs. In a stagflationary world, companies can’t easily pass these higher costs on to consumers by raising prices without seeing a collapse in sales.
As a result, some analysts warn that global sharemarkets will see further selling, with some predicting the S&P 500 will drop a further 23 per cent, to about 3000 points.
Similarly, the threat of inflation means that bonds don’t offer a safe refuge for investors.
Usually, bond prices rise – pushing yields lower – in periods of recession because investors expect central banks will cut interest rates to boost economic activity.
The problem with stagflation is that central banks can’t boost growth by loosening monetary policy because inflation is already too high. Indeed, central bankers may feel compelled to keep raising interest rates to tame inflation, even though growth is anaemic.
The combination of high inflation with sluggish economic growth makes it much more difficult for investors to pick whether bond yields will move higher, or lower.
Similarly, investors who decide that they’re better off taking refuge in cash could find themselves nursing hefty losses – especially after they factor in inflation.
Normally, investors boost their cash holdings as the economy turns down because slowing growth typically translates into falling inflation.
But in a stagflationary world, this strategy doesn’t work. Even if the interest they earn on their savings matches inflation, investors are taxed on their nominal earnings. And this means that their real purchasing power is quickly eroded.
What’s more, investors face the risk that central banks might tolerate a period where inflation is running at 4 per cent to 5 per cent to offset the long period before the pandemic when inflation was below their target.
If central banks were to only lift their cash rate to, say, 3 per cent, investors would face an after-tax return of between 1.5 to 2 per cent, depending on their tax rate.
But this means that investors are going backwards by about 3 percentage points each year. It only takes a few years for them to find that their purchasing power has fallen by 10 per cent in real, or inflation-adjusted, terms.
Similarly, real estate is a riskier proposition in a stagflationary environment, where central banks are forced to increase rates even though growth is sluggish.
It’s likely that the global surge in property prices over the past two years will be partly reversed as interest rates rise and borrowers find themselves facing higher repayments.
Meanwhile, yields on commercial real estate, which have fallen to about 4 per cent, don’t offer investors a sufficient risk premium at a time when the yield on Australian 10-year bonds is 3.3 per cent.
Then there is the growing risk of technological obsolescence.
Retail centres are now struggling with the growing popularity of online shopping, while the huge shift to working from home will likely reduce demand for office space.
In periods of stagflation, even neighbourhood shopping centres are at risk. People may still visit local shops for their groceries, but they’ll likely spend less freely in coffee shops, or florists, than previously.
Even industrial property is at risk, as the increasing trend towards warehouse automation is reducing demand for older-style buildings.
Other assets touted as inflation hedges – such as gold and digital currencies – have already proved disappointing for investors.
The gold price jumped past $US2000 an ounce in early March as investors sought a safe haven for their money at a time of war and surging inflation, but it has now fallen back to about $US1850 an ounce.
Meanwhile, the price of cryptocurrencies such as bitcoin and ether have fallen in tandem with tech stocks.
Of course, investors will be tempted to find refuge in private equity and hedge funds, which have delivered strong returns in periods of falling interest rates.
But very few private equity funds or hedge fund managers have ever experienced a stagflationary environment, and so it’s questionable whether they’ll know how to navigate these new conditions.
It’s entirely likely that both private equity and hedge funds will suffer the same problems as other asset classes, although magnified by higher leverage.