Economic scenarios must be faced and understood, not escaped.
Today we will deal with one of the most interesting topics for me the macroeconomic environments of the economy. There are four situations (one is divided into two because it gives different results on the economy) that are created by the possible combinations of inflation and growth.
Below you can see their position, their frequency in history and the return of the shares in the meantime.
Let’s try to give some definitions:
Warming (Overheat): starting off from a rising growth regime, we have inflation picking up to the point where it slows down growth.
Too Hot (Stagflation): rising inflation chokes off growth
Cooling (Reflation): growth falls further and brings inflation along
Too Cold (deflation): to the point where inflation turns negative and activity contracts severely
Perfection (Recovery): growth is positive and inflation is low
We understand that economic growth alone is not the only condition to earn the most, but low inflation is also needed. Sorry emerging markets, you will do better in the future when your growth is more stable).
Best asset classes for each economic scenario
Here are some examples
But why do they work? Well, for stocks, a recovery situation helps because if inflation is not high, people are not afraid and spend their salaries more quietly. In addition, the interests are lower and this helps companies to finance their projects. GDP growth also increases salaries (in theory). One way to calculate GDP is the sum of a nation’s salaries and pensions).
If you look closely in stagflation (theoretically the worst scenario for stocks) you can still see that there are categories that can resist the collapse. These sectors are normally called defensive sectors and are important for resisting collapses. For example, the utilities sector manages to keep its revenues in stagflation. This is because even if the economy is bad no one would be without light, water or gas at least in the short term.
Bonds are to be bought at the beginning of a reflexive phase. In this case because soon the decrease in inflation will lead to a lowering of interest rates and this will help to increase their value. Remember that the rise / fall in bond prices is inversely proportional to the trend in interest rates.
Light lesson today, but in my opinion also very interesting. Everywhere we always talk about GDP growth, omitting inflation and its importance. Economic scenarios need our attention to understand them during our portfolio construction