A growing economy and falling unemployment define today’s economic panorama. So, the answer is probably no for those of you wondering if we are heading into stagflation. On the flip side, economists agree that the risks of such a situation are ever-increasing. Exogenous factors such as the Russian-Ukrainian conflict, new Covid variants, the Monkeypox outbreak, extended lockdowns in mainland China, and lower household spending could weigh on growth. Both institutional and retail investors are looking for ways to preserve the purchasing power of their capital. This article reviews what stagflation is and how to avoid falling victim to its aftermath. 

What is Stagflation?

Stagflation has the worst of both worlds; not just high inflation on the one side or stagnation on the other, but both together. It creates the perfect storm as it is characterized by high inflation, reduced output, and high unemployment. It becomes very tricky for the Fed and any other policymakers to regain control of the situation. In reality, they can’t tackle both inflation and unemployment simultaneously. They can either increase interest rates to reduce inflation or cut them to reduce unemployment. 

Loss of Purchasing Power 

Inflation reflects the decline in the purchasing power of any given currency. It is measured using a metric known as the Consumer Price Index (CPI), which measures the percentage change in the general price levels of a fixed basket of goods and services in a given economy over a specified period. According to Canada Statistics, the CPI basket is comprised of 8 major components: 

1. Food
2. Shelter
3. Household operations, furnishings and equipment
4. Clothing and footwear
5. Transportation
6. Health and personal care
7. Recreation, education, and reading
8. Alcoholic beverages, tobacco products, and recreational cannabis 

In simpler terms, when inflation rises in Canada, the CAD loses more value and buys fewer goods and services than before.

Unemployment 

Not everyone that is jobless is considered unemployed. Unemployment is a measure of able-bodied citizens who are actively seeking employment. It is calculated as a fraction of the total workforce. The unemployment rate is the percentage of the labour force without a job. The unemployment rate moves in the wake of changing economic circumstances. It is believed to be a lagging economic indicator. The unemployment rate is anticipated to fall when the economy is heating and the job market is saturated. It is expected to fall, in contrast, when the economy is receding and jobs are scarce.  

Is Stagflation Looming on The Horizon? 

Canada’s annual inflation has been consistently rising since the start of the year. Inflation reached 6.8% in April, slightly above market expectation, breaching its 30-year high since January 1991. Despite that, price levels are quickening towards their highest, and stagflation is looking unlikely now. The economy is going strong, overheating, and the unemployment rate is at its lowest level. In April, unemployment dropped to 5.2% from 5.3%, hitting the lowest rate on record, supported by a robust post covid labour market recovery.  

However, it’s not sunshine and rainbows yet. The risk of stagflation still lingers, and the odds are higher than before. Developments on the military front in Eastern Europe could push up global uncertainty sending commodities such as oil, gas, wheat, and food prices higher. Similarly, the threat of new covid variants and the Monkeypox outbreak could further extend supply chain disruptions. Not to mention the effects of renewed lockdowns in mainland China affecting demand in the world’s second-largest economy and disrupting supply chains. 

How to Fight Stagflation?

Even if stagflation is off-limits now, slower growth isn’t out of the picture. There is some evidence suggesting that the Fed raising interest rates has increased the chances of a recession in the past. This, coupled with a few bad decisions from policymakers, can trigger headwinds of stagflation. In this case, as preventive measures, investors can take practical steps to escape from the stagflation boogeyman. On the personal finance side, investors can establish a budget and prioritize expenditures and savings to align with financial goals.

Furthermore, they can look for a means to increase their income. Similarly, investors can resort to capital markets to hedge the stagflation risk noting that it isn’t wise to panic and liquidate all their investments. They should take a step back, reassess their strategy, focus on diversification and consider putting their capital in assets that tend to appreciate with rising inflation. Sectors such as energy, industrial commodities (oil, gas, coal, uranium, copper, etc.), agriculture, and precious metals are key areas expected to fare well in a stagflation environment. They are a source of input costs for businesses and a key component of inflation indices and, as such, are expected to perform in line with inflation. Similarly, REITs can pass-through price increases to consumers and thus offer a partial inflation hedge. It is also considered advisable to steer away from any kind of bonds, except inflation linked bonds, as the high inflation will erode coupon and principal payment. 

Stagflation Proof ETFs

ETFs allow investors to overcome the complexities of picking individual securities. They provide investors with an easy and convenient way to gain exposure to their sectors that are less affected by stagflation. The NEO ETF Screener is a great tool to filter out and compare such ETFs.

Energy ETFs

There are 14 energy ETFs currently listed and trading in Canada. Assets under management reached CAD$4.2 billion while attracting CAD$1 billion year-to-date. 

Top 5 Energy ETFs’ year-to-date performance (the ETFs are ranked by assets under management):

• iShares S&P/TSX Capped Energy Index ETF (XEG): 66.18%
• Ninepoint Energy Fund (NNRG): 59.91%
• CI Energy Giants Covered Call ETF (NXF.B): 46.65%
• CI Energy Giants Covered Call ETF (NXF): 44.88%
• Horizons S&P/TSX Capped Energy Index ETF (HXE): 63.82%

Commodity ETFs

The screener identifies 41 ETFs investing in a range of commodities with a combined CAD$2.8 billion of assets under management and a cash influx of CAD$45 million year-to-date. A few commodity ETFs’ year-to-date performances (the ETFs are ranked by assets under management):

• iShares Gold Bullion ETF (CGL): 1.54%
• iShares Gold Bullion ETF (CGL.C): 2.48%
• Purpose Gold Bullion Fund ETF (KILO.B): 2.15% 
• Horizons NYMEX Crude Oil ETF (HUC): 43.95%
• Horizons NYMEX Natural Gas ETF (HUN): 118.36% 

REIT ETFs

Assets under management for REIT ETFs hit CAD$2.6 billion spread across 8 ETFs, excluding leveraged and inverse ETFs. Almost all these products have failed to outperform the broader market so far this year.

Top 5 REIT ETFs’ year-to-date performance (the ETFs are ranked by assets under management):

• iShares S&P/TSX Capped REIT Index ETF (XRE): -9.42%
• CI First Asset Canadian REIT ETF (RIT): -11.08%
• CI First Asset Canadian REIT ETF (ZRE): -7.80%
• Horizons Equal Weight Canada REIT Index ETF (HCRE): -9.11%
• Purpose Real Estate Income Fund ETF (PHR): -10.22%

Agriculture ETFs

According to the NEO ETF Screener, the iShares Global Agriculture Index ETF (COW) is the sole ETF aligned to the agribusiness theme. This ETF returned 20.55% year-to-date while holding CAD$453 million of assets. It has attracted CAD$82 million of investor capital so far this year.

Data for this article is as of May 27th, 2022.