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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Good morning. It can take a long time for economic damage from big shocks to become apparent, and even longer for politicians to admit there has been a shock at all. Yesterday, almost 10 years after the UK’s vote to leave the EU, Prime Minister Keir Starmer acknowledged that the rupture “did deep damage to our economy”. How long will it take for the US establishment to face up to the damage done by the Iran war? Investors are already fretting about the inflation it could inject back into the financial system, even despite growing signs that Donald Trump is growing weary with the conflict, and some airlines are entering “emergency mode” as fuel prices soar. Which immediate effects are you most worried about? Tell us before we disappear for the long weekend (no newsletter tomorrow!): [email protected].
Staggering towards stagflation (again)
Stagflation risk is back, and don’t just take our word for it: our colleagues did a very meaty Big Read on it the other day. It’s worth your time.
It landed on the observation from the economist Kenneth Rogoff, formerly of the IMF, that “the Iran war is shaping up as the biggest stagflationary shock the world has seen in five decades”. Gulp.
We can already see this in stocks and bonds, which both had a very bad, no good March, reminiscent of broad market performance in 2022, which, as we’ve written before, stank.
So, what can investors do to prepare for the possibility of lower growth and higher inflation at the same time? It’s tricky.
Step one, says Duncan Lamont at Schroders, is not to panic. In a note released last week, he said that while stagflation is grim for stocks, it’s not necessarily the end of the world. Looking back over data from the past 100 years, he says:
The median yearly real return in a stagflation-year has been about 0 per cent. This is less than investors would typically want from equities over the long-run, but getting close to inflation in a high inflation environment is not a bad outcome.
In addition, in about half of these years, [stocks] generated a positive real return. And, when these real returns have been positive, they have tended to be strong, averaging about 16 per cent. In the interests of balance, it is worth pointing out that when they were negative, they averaged -14 per cent.
Only eight stagflation years produced positive stock market performances — not a huge sample to work with. But this does illustrate that there’s a case for preparing for the worst and hoping for the best.
Also, some sectors seem to do OK in this environment. Here Lamont’s data does not go back quite as far, so it’s unwise to draw overly confident conclusions. But the results are fairly intuitive: utilities, consumer staples, energy and materials hold up pretty well, as does healthcare. Real estate is a mixed bag, while consumer discretionary stocks, IT and financials tend to suffer.
If only there was a advanced-economy stock market out there that was largely devoid of exciting IT stocks and instead was stuffed with dull utilities, resources companies and the like. Oh wait! As Lamont says, the UK could make boring great again:
Its 16 per cent allocation to the defensive consumer staples sector and 10 per cent to energy are more than double any other major market has to either. Plus, it has barely any exposure to the IT or communication services sectors compared with elsewhere. Like Europe, the UK is overweight financials. While not without risk, there is definite potential for negative perceptions about the UK market’s boring, defensive, nature to turn to its advantage.
Illustrating his point, the FTSE 100 is, despite everything, still up by 4 per cent this year, while the US is down 4 per cent. (It’s worth noting, though, that UK housebuilders are taking a beating at the moment.)
Another possibility here is that stagflation risk has already been baked into markets, possibly excessively so. Emmanuel Cau and colleagues at Barclays point out that in Europe, over 90 per cent of sectors in the stock market have taken a hit, including sectors that are not typically overly sensitive.
In the past decade, there have been 12 instances when about 90 per cent of sectors fell over a month. This was followed by MSCI Europe rebounding two-thirds of the time, by a median of 2.5 per cent. When it did not work, the median drawdown was -0.6 per cent. So while the current dislocation doesn’t guarantee a reversal, it does make the current set-up look more interesting, for the brave.
The problem with all this is that everyone knows that, on the geopolitical side of things, no one knows anything. We remain at the whim of a US president whose strategy is unclear at best and an Iranian regime that is not backing down.
For now, though, there’s a decent case for keeping a cool head.
One good read
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