Higher risk of stagflation has implications for asset allocation. Investors should consider alternative asset classes such as real estate, commodity-related stocks, defensive stocks and perhaps gold.

Published on April 19, 2022 by David Bakkegaard Karsbøl, CIO at Selected Group

In practice, all big moves in financial markets are caused by market participants being surprised by something. If everyone fears further tightening of monetary policy by central banks and expects a high inflation number, a lower inflation number will be received positively because that part of the fear turned out to be unfounded. We saw this last week.

Apart from monetary policy - which determines the price and abundance of money - few things are as important for the valuation of financial assets as the outlook for economic activity.

Equity investors fear a recession more than almost anything else because corporate earnings typically fall during a recession. The combination of shrinking order books and fixed costs can quickly turn a nice set of financial statements into a horror story. And since equities are usually valued according to their ability to generate earnings, this translates into poor stock returns at the prospect of a recession.

Conversely, in the case of bonds, the prospect of a recession typically leads bond investors to expect lower growth in consumption and investment and increased idle capacity in the production system. This will weaken aggregate demand in society, leading to lower inflation and lower interest rates (which is the same as higher bond prices).

Therefore, as an investor, you should always consider the likelihood of a recession. You do not want to buy shares at a time when the stock market is priced above the pink clouds because everyone expects high and rising earnings and is willing to pay for access to high growth rates. Disappointments lead to lower share prices.

Conversely, buying stocks at the prospect of a recession can actually sometimes make a lot of sense because they are often cheaper when there is a consensus that earnings are at risk of weakening. In short, therefore, investing is all about guessing what everyone else is going to do before they know it themselves. And if enough market participants expect a recession to happen soon, it limits the negative outcome if it does happen.

At present, we have seen a rather dramatic slowdown in global economic activity over the summer and the slowdown is very likely to continue into the summer of 2023. Nevertheless, the stock market has so far performed reasonably well in recent months. This is probably because so many market participants have been expecting a recession for quite some time and have thus not been surprised by developments.

Since 1970, the Federal Reserve has been collecting questionnaires from economists working on forecasting the business cycle. At no time in these 52 years has such a large share (44%) of economists expected a recession within the following 12 months. Even immediately before the financial crisis, only around 25% expected an imminent recession.

Against this background, it seems that it will take major disappointments and a cyclical downturn to become a serious concern for equity investors in the coming months. Therefore, although equities are still expensively priced - especially relative to bonds - we may well be close to the bottom of the equity market.