Stagflation Trading Strategy (Backtest And Example)
Last Updated on April 18, 2023
As inflation bit harder in 2022, one common theme in the media was whether the world was going to into a period of stagflation. Even the World Bank issued a warning in that regard. Although the world is not in a stagflation, as of January 2023, if it were to come, do you have a stagflation trading strategy?
A stagflation trading strategy refers to the trading and investment techniques you can use to make money, or at least protect your wealth, during a period of stagflation. This would include the assets to trade, the directions to trade, and how to spread your risks across different assets. A good strategy is to move into assets, such as real estate, gold, agricultural commodities, bonds, and some value stocks that can weather the storm. If you are an experienced trader, you can also short-sell stocks that are likely to be hard hit by stagflation.
In this post, we answer some questions about the stagflation trading strategy and we end it with a backtest.
What is stagflation, and how does it differ from other economic conditions?
Stagflation is an economic situation where there is a simultaneous occurrence of inflation and stagnation. It is a period of rising prices of products and services (inflation), poor economic growth (as measured by GDP), and high employment. The high inflation in stagflation is usually followed by an aggressive monetary policy (raised interest rates) in an attempt to stop the inflation, but this stagnates or slows the economy, leading to high unemployment rates.
Stagflation is an unnatural situation because inflation is not supposed to occur in a weak economy. In a normal situation, slow growth prevents inflation since consumer demand drops enough to keep prices from rising. Stagflation results when external forces disrupt the normal market cycle. Such forces include situations like geopolitical wars and trade wars that cause persistently stubborn inflation in the midst of already poor economic growth, as well as conflicting contractionary and expansionary fiscal policies that disrupt normal market functioning.
Stagflation usually presents a challenge to economic policymakers because the tools used to combat inflation (raising interest rates) typically raise unemployment and the tool to combat slow growth and high unemployment (lowering interest rates) spurs inflation.
What is a stagflation trading strategy?
A stagflation trading strategy refers to the trading and investment techniques you can use to make money, or at least protect your wealth, during a period of stagflation. This would include the assets to trade, the directions to trade, and how to spread your risks across different assets.
During periods of stagflation, the assets that weather the storm and perform well include Treasury bonds, agricultural commodities, precious metals, real estate, and maybe, value stocks if you can spot good ones.
Your stagflation strategy should be about balancing your portfolios by simply diversifying into these assets that tend to perform better during an economic crisis. This would involve reducing your exposure to higher-risk assets and moving into assets that will weather the stagflation storm better. Another play during stagflation is to identify stocks that are likely to be hard hit by a stagflationary environment and short-sell them.
How do you identify stagflationary trends in the market?
You can identify stagflationary trends in the economy by studying key economic indicators that can signal the setting of stagflation. The main economic indicators to watch include the gross domestic product (GDP), which is used to measure the growth of the economy; the Non-Farm Payrolls and wage reports, which show the employment situation; and the consumer price index (CPI) and personal consumption expenditure (PCE), which are used to measure inflation rates.
By monitoring these key economic data, you can identify when there is stagnant economic growth, high unemployment rates, and high inflation rates, which are the three characteristics of a stagflationary trend.
What types of assets perform well during stagflationary periods?
The assets that perform better than the rest of the market during stagflationary periods include:
- Real estate: These investments tend to have a low correlation with stocks. Moreover, people still need housing during an economic slowdown. Generally, rental prices usually move with inflation, and in some cases, they can outpace it, even if the value of the dollar is declining.
- Gold and silver: Precious metals like gold and silver are often used as a hedge against inflation since their values tend to increase even as the value of fiat currencies drops. Although investments in gold and silver may not generate income, they can help to offset stock market risk during stagflation periods.
- Commodities: They are often the raw materials that are used to make other products, and during stagflation, agriculture and oil commodities, tend to outperform stocks and bonds. So, while economic activity slows during a period of stagflation, the prices of these commodities benefit from the inflationary pressures on the market.
- Bonds: In a stagflationary market, where traditional investment options underperform, bonds offer a relatively safe haven for investors. There are inflation-linked bonds, whose returns are linked to the consumer price index (CPI); they tend to offer stable returns during times of high inflation.
- Value stocks: These are stocks that are undervalued by the market. If you can spot good ones, these stocks may be bargain buys when stock prices are lower due to stagflation. To play this, it is important to avoid value traps, which are stocks that appear to be undervalued but actually are not.
How do you adjust your portfolio to prepare for stagflation?
To adjust your portfolio in preparation for stagflation, you have to move away from risky assets, such as stocks, junk bonds, and cryptocurrencies, to safe-haven assets, such as gold, silver, commodities, real estate, Treasury bonds, and high-quality value stocks.
By spreading your investments across those assets that are known to weather the storm of stagflation, you minimize your risk while increasing your chances of returns. The good thing about Treasury bonds is that they offer you some returns and might also increase in value; the same with real estate.
What are some specific trading strategies for profiting from stagflation?
These are some strategies you can try out:
- Investing in real estate: You can invest in real estate during stagflation, as rental prices usually move with inflation, and in some cases, they can outpace it, even if the value of the dollar is declining. Even the asset would also increase in value due to high inflation.
- Trading gold and silver: You can trade gold and silver during such periods. They often serve as a hedge against inflation since their values tend to increase even as the value of fiat currencies drops.
- Investing in commodities: You can invest in agricultural and oil commodities, as they tend to rise in value during periods of high inflation.
- Investing in high-quality value stocks: A long-term play could be to invest in value stocks, but you must be careful to pick the right stocks. It may take a long time for the stocks to fully realize their value and make good gains.
- Investing in bonds: Investors consider Treasury bonds a safe-haven asset and use them to weather the storm of stagflation. Inflation-linked bonds are also very good in this situation.
- Short-selling stocks: If you are an experienced stock trader, you can short-sell stocks that are hard hit by stagflation.
How do you manage risk when implementing stagflationary trading strategies?
When implementing stagflationary trading strategies, you can manage risk by diversifying your investments into different assets and strategies. You can use a combination of all the strategies mentioned above if you have the capacity so that if one is not doing so well, the others would offset the losses.
For example, if your play in buying high-quality value stocks seems too early and the overall market is too bearish for those stocks to perform, the profits from your real estate investment would offset the temporary losses in the stocks you bought.
How do central bank policies impact stagflationary trends and trading strategies?
Central bank policies can lead to stagflation results when there are conflicting contractionary and expansionary monetary and fiscal policies that disrupt normal market functioning. For example, one of the factors that led to the famous stagflation of the 1970s was that the then federal government manipulated its currency to spur economic growth, and at the same time, restricted supply with wage-price controls.
Once stagflation starts, it usually presents a challenge to central banks because the tools used to combat inflation (raising interest rates) typically raise unemployment, and the tool to combat slow growth and high unemployment (lowering interest rates) spurs inflation.
How do you adjust your strategy as stagflationary trends change?
By monitoring stagflationary trends, you can spot when they are changing and adjust your strategy accordingly. When the economy is about to go into a stagflationary period, you move your money into assets that can weather the storm.
When the market is moving from a stagflationary to a normal situation, you can gradually rebalance your portfolio to include risky assets such as stocks, cryptocurrencies, and junk bonds.
How do you monitor economic indicators related to stagflation?
The economic indicators that you can use to monitor stagflation are the GDP, Non-Farm Payrolls, CPI, and PCE. Those data are released every month, except the GDP which is often quarterly. You can find the schedule for those data from the website of the relevant government agencies and also from the economic calendars of any financial website.
How do you determine the appropriate level of leverage to use in stagflationary trades?
It depends on your experience and the asset you are trading. If you are an amateur, it is better to avoid using leverage at all as the markets are usually highly unpredictable during stagflation. For example, commodity markets can be very volatile and make huge swings.
How does stagflation impact the value of debt?
When inflation is rising, the longer a debt remains unpaid, the less the value of that debt could be worth to you in terms of spending power. However, with the accompanying slow growth and high unemployment rates, the means to repay the debts may even be lacking. So, it presents a lose-lose situation. Moreover, if the loan is based on a floating interest rate, as against a fixed rate, the rising rates enforced by central banks to fight inflation can make servicing debts much more expensive during stagflation.
How do changes in the supply and demand for goods and services affect stagflationary trends?
Stagflation can result when external forces, such as geopolitical and trade wars, disrupt the normal demand and supply of important goods and services, creating a supply shortage. With more demand than supply, the prices of goods and services rise.
How do changes in consumer and business confidence impact stagflationary trends?
Changes in consumer and business confidence can worsen stagflationary trends because when people are worried about the economy or unemployment, they tend to spend less to save more money. But they have to spend on essential goods and services, like energy and groceries. So, the prices of such items remain high, while those of nonessential items decline with time. Businesses may be discouraged from increasing production.
How do changes in global economic conditions affect stagflationary trends in a particular market or country?
With the world becoming increasingly connected, any economic mishap in one part of the world can have a ripple effect in other parts of the world almost immediately. The reason information is easily disseminated and people can easily move funds from one region to another. Global economic conditions tend to affect all countries because the markets are connected through open markets policies.
How do you differentiate between temporary stagflation and sustained stagflationary cycles?
Temporary stagflation is, as the name implies, short-lived — probably lasting for a business quarter. It often does portend any danger and the market corrects itself. Sustained stagflation, on the other hand, can last for two or more quarters and can have a devastating effect on the economy.
How do you anticipate and respond to potential stagflationary spirals?
You should monitor economic data, such as the GDP, Non-Farm Payrolls, CPI, and PCE, which are published every month by the relevant agencies. These can be found data from the websites of the agencies that publish them or from the economic calendar of any financial website.
The “All Weather Portfolio” — does it hedge against stagflation?
Created by hedge fund manager Ray Dalio, the “All Weather Portfolio” is a diversified asset mix consisting of the following:
- 40% long-term bonds
- 30% stocks
- 15% intermediate-term bonds
- 7.5% gold
- 7.5% commodities
Several backtested results show that the “All Weather Portfolio” tends to fair better than most other asset allocation methods during periods of stagflation.
Stagflation Trading Strategy backtest
A complete backtest of a stagflation trading strategy with strict trading rules and settings is coming shortly.