What is Stagflation?
Stagflation is the economic condition characterised by 2 things:
- Slow economic growth
- High inflation
Why discuss Stagflation?
A large part of the globe, esp the West, is staring at stagflation.
This is one of the worst economic conditions because:
You try to improve economic growth through fiscal stimulus or interest rate cuts, but then you risk heating up the inflation.
You try to control inflation by raising interest rates, and you risk further growth slowdown.
Understanding from company's context
Let's say ABC company manufactures 100 units at Rs.50 and sells at Rs.80, thus earning a profit of Rs.3000.
Now comes the stagflation where the company is witnessing weak demand and high manufacturing cost.
It is able to sell only 75 units while manufacturing cost has gone up to Rs. 60, thus earning a profit of Rs.1500.
Profits of the company have been cut in half.
Catch-22 situation
What can company do to improve its profits?
If it tries to increase its price to maintain margins, sales volume will decline.
If it tries to improve sales volume by reducing prices, its margins will be hurt.
In short, the company is in a catch-22 situation with not many alternatives.
Learning from history
Stagflation last made its mark in 1970s when US suffered high inflation, high unemployment and low growth.
The period was marked with asset price declines in both equity and debt markets.
Gold was the only saviour for the investors.
US Fed had to raise interest rates aggressively to come out from stagflation, but it led to recession in the US.
What should investors do?
Investors should pick stocks with following characterstics:
- Companies having pricing power, thus can pass on the cost increase to its customers.
- Companies in non-discretionary products/services.
- Companies facing less input cost inflation.
- Companies trading at modest valuations, which provides margin of safety.
DISCLAIMER: This blog is solely for educational purposes and not to offer any investment advice. Please do your own research or consult a financial advisor before making any investment decisions.
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