How to cope with inflation, deflation and stagflation

Bottom-up stock picking (choosing a stock based on its individual attributes) often comes at the expense of macro analysis. In fact, some managers say economy and industry trends have little or no place in the selection process. Another approach is to allow macro trends to influence asset-class and sector-weighting decisions. Deeper analysis then separates strong names from throwaways.

Three experts say that macro matters, and explain how to respond to inflation, deflation, hyperinflation and stagflation.

The Good: Growth-Based Inflation

Let’s say the economy’s growing, prices and wages are gradually rising, and unemployment’s dropping. That would be viewed as good inflation.

In this situation, nominal and real interest rates would rise, so avoid fixed income, says Paul Taylor, chief investment officer, asset allocation at BMO Asset Management. “Also avoid preferred and high-yielding common shares because they take a hit as rates jump.” Sectors to sidestep: utilities, consumer staples and telecoms.

Look instead to assets with built-in inflation hedges. “The best examples,” says Taylor, “are common equities in the energy, materials, information technology and consumer discretionary sectors.”

When inflation stems from strong growth, expect Canadian equities to be the best performers. “There’s a high correlation between global growth and outperformance of our equity market. Growth means more resource consumption — a boon for the TSX,” Taylor explains. “EAFE [Europe, Australasia, Far East] stocks would rank second, followed by U.S. equities.”

Jillian Bryan, VP and portfolio manager at TD Wealth Private Investment Advice, suggests avoiding the U.S. and Canadian dollars because those currencies would be slipping. “Put it in something [central banks] can’t print more of, like gold.”

Floating-rate preferred stocks would also be good choices in this environment, Bryan says. “Emerging market equities should also do well when inflation weakens the U.S. dollar. But the EM index is volatile, so it’s not a buy-and-hold investment. Get in when trend lines show it’s a good buy, but don’t be greedy.” Take a decent return and run.

Matt Skipp, president and chief investment officer at SW8 Asset Management, says banks would be another strong choice because they benefit from higher rates. He also likes consumer discretionary because growth-based inflation means people will have disposable income.

The Bad: Deflation

Steadily falling prices define a deflationary environment. And that’s a difficult situation for policymakers to fix, says Taylor, primarily because of consumer reaction.

“Someone’s thinking of buying a car, but she waits six months because she expects it to get cheaper. Six months later she sees not only did the price fall, it came down more than expected — thanks to her own behaviour. So she waits another six months. And that,” says Taylor, “is the vicious circle of deflation.”

An appropriate investment strategy would be to do the opposite of what you’d do under inflation. “Get the longest-duration bonds you can,” he says. “This allows you to lock in the coupon while rates continue to fall.” He also suggests gold, perpetual preferred shares, hard assets and the U.S. dollar.

Bryan says cash is king under deflation, but stick to major currencies. Also add high-quality, dividend-paying stocks. “While most companies are hurting because of weak margins, stronger firms that dominate their industries will be more resilient.”

Skipp too is buying assets “that will hold their value.” Recession-resistant businesses with strong balance sheets are first on his list.

An example is Constellation Brands, a global beer, wine and spirits company. “People will buy booze no matter what the economic environment — it’s effectively a staple.”

He’s also long on technology, but not on consumer product firms like Apple. “We focus instead on software or cloud computing developers because they’re not as sensitive to the whims of price deflation.”

Deflation’s bad for commodities, and as Chinese and broader global demand has slowed, Canada has felt the pain.

“It’s a volatile sector, and we like to go short on the first derivatives,” Skipp says. This means shorting firms that service the commodity industry, like Caterpillar and Finning International, which provide heavy equipment.

He’s also shorting consumer discretionary and firms with heavily leveraged balance sheets.

In a deflationary environment, Bryan would short debt-laden companies, “given the risk they face of becoming insolvent.”

The Ugly: Hyperinflation & Stagflation

Hyperinflation

Under hyperinflation, own what you’d short in a deflationary environment, says Skipp.

“So you’re now long on the Caterpillar and Finning stocks you previously shorted. Also, get direct exposure to food companies and commodities.”

On the short side are utilities, for example. “They’re quasi-bonds with stable revenue streams and cash flow, but they’re regulated, so they can’t raise prices like the guy down the street who’s charging you a dollar more for a tomato.”

Stagflation

It doesn’t get much worse than stagflation: high inflation and interest rates coupled with low growth and high unemployment. The last time we dealt with this was the early 1980s, notes Taylor.

He suggests the same strategy you’d use under inflation, but with a greater focus on commodities “because you want assets that benefit from the uptrend in pricing.”

Skipp suggests multinationals would do well in this environment because their labour costs come down. And while slow growth doesn’t help their bottom lines, it can cripple their smaller competitors. This gives big players greater competitive advantage.

Low growth, he adds, means portfolios should beef up exposure to bond proxies like REITs, utilities and telecoms.