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Spotlight on Stagflation

As the yield curve signals slower economic activity, stagflation moves to the centre stage. 

Head of Portfolio Management

Stagflation – is on Investors’ Minds for a Good Reason

Stagflation is the hot topic for investors right now and for a good reason. The likelihood of stagflation (the combination of high inflation with slowing growth) is fast becoming a base case for investors. Figure 1 below shows the surge in the stagflation topic across investor research, news and company filings. Stagflation warrants attention as most investors are not old enough to have experienced it and historically it has proven a difficult economic environment and it is likely to test investment styles that favour low inflation and moderate growth.

Figure 1: Stagflation – the Topic Investors Are Focused On
Search Results Over Time

Persistently high inflation is now forcing the central banks to tighten, increasing the likelihood of slower economic growth hence the concern about the dreaded “stagflation”.

Markets Point to Slower Economic Growth

The yield curve is a useful guide for economic growth. The yield curve embodies the market’s expectations for both the future course of monetary policy (the 2-year yield) as well as expectation for future growth (the 10-year yield). Together, they provide the markets assessment as to whether monetary policy expectations will be pro-growth or anti-growth. Many commentators will focus on whether the curve has gone below zero and whether this will signal a recession but it is unnecessary to go this far. The broader signal is simpler – a falling yield curve increases the chance of slower growth and conversely a steepening yield curve increases the chance of improving growth. In the last 12 months the yield curve has moved from 150 to zero which is tells us the markets now expects slower economic growth ahead. 

Figure 2: The US Yield Curve and Economic Recessions Since 1986


Figure 2 above shows the 10-2 year US yield curve in the blue line as well as both its components, the 2-year yield in red and the 10-year yield in green. Historically, when the yield curve has moved below zero we have seen recessions in the economy in the subsequent 12 to 24 months. US and Australian recessions are highlighted in grey.

Figure 3: Best and Worst Sectors for a Falling Yield Curve

Top 3 Sectors Bottom 3 Sectors
Health Care Communication Services
Utilities Banks
Technology Financials

Source: State Street Global Advisors, Factset as of 31 March 2022. Past performance is not a reliable indicator of future performance. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. 

Thematically we have found that quality, low volatility, momentum and growth have all historically outperformed in a falling yield curve environment. 

The Bottom Line 

Investors are increasingly concerned about a stagflation economic environment. As the yield curve points to slower economic growth, investors may look to diversify their concentrated holdings towards sectors and styles that have historically outperformed in a more difficult economic environment.

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