Columnists

How stagflation is threatening major global economies today

beijing

Chinese customers shop at the vegetable section of a supermarket in Beijing. PHOTO | AFP

Stagflation is defined as a prolonged period in which an economy experiences persistently high inflation, high unemployment, and stagnant demand. The current economic challenges arising from the Russia-Ukraine war are a major factor contributing to high inflation hence higher food and energy prices globally.

Major world economies are experiencing record-high inflation rates. For instance, the US inflation rate is at 8.5 percent, a 40-year high. This can largely be attributed to the massive monetary easing that happened between 2020 and 2021 to cushion the economy from the effects of covid-19.

In addition, US has experienced higher food and energy prices because of supply chain bottlenecks in the last two years. The extremely low-interest rates were also a major contributor to the current high inflation as the cost of borrowing was significantly reduced during the pandemic.

Eurozone is experiencing a 7.4 percent inflation rate with a spike in energy costs contributing significantly to the high level. The record-low interest rates of zero percent combined with the Russia-Ukraine war are arguably the biggest contributors to the current Eurozone headline inflation.

To control the persistently rising inflation, major central banks are implementing a series of interest rate hikes. These hikes are making the cost of borrowing go higher and making people and businesses spend more cash on interest payments.

This leaves them with less disposable income. As a result, the people and businesses buy fewer products leading to weakened aggregate demand in the economy. Weakened demand is a major indicator of an economy going through stagflation.

People and businesses that don’t want to pay high-interest payments tend to postpone their projects that involve debt financing.

This reduces the near-future economic growth as the projects could have created value and employment. This feature tends to have a huge impact on real estate construction projects, which are capital and labour-intensive.

When interest rates are low, people and businesses tend to borrow more cash for use in investments and other spending. In the current period where interest rates are rapidly rising, people are expected to reduce borrowing while increasing their savings rate to take advantage of the high-interest payments. This implies fewer investments in productive ventures which indicates less creation of jobs.

Stagflation has a direct negative impact on stocks. A period of high-interest rates makes the cost of borrowing higher and companies may not take loans to take on investment in capital goods.

Coupled with weakening aggregate demand, companies tend to experience lower sales revenues which in turn affects their share price negatively.

Since most experienced investors understand the effect of stagflation on stocks, the moment a central bank announces a hike in interest rates to control inflation, investors rapidly dump their stocks and run for more defensive stocks such as energy, aerospace and defense, consumer staples, and luxury goods stocks.

These are stocks that can withstand a period of high inflation, high-interest rates, and weakening demand.

The Great Resignation, a movement that started in 2020 in the US has gone global. It refers to a pattern where people are voluntarily leaving their jobs in search of those that are offering better working conditions, flexibility, and higher pay.

This has led to companies adjusting their wages and workweek structure to attract more talent, significantly raising the unit labour costs.

To cater for higher wages, firms can respond in two ways. First, they may consider hiking their product prices to gain sufficient sales revenue. This leads to higher inflation which is synonymous with stagflation.

On the other hand, they may consider surviving with higher labour costs without hiking their product prices. This leads to lower sales revenues which may drive the stock prices down, a common trend in a stagflation environment.

The rising covid-19 cases in China are leading to lockdowns and other measures that are reducing manufacturing activity in the country.

As experienced during the first phase of covid-19 in 2020, a slowdown in manufacturing production may lead to further pressure on global supply chains which results in higher shipping costs and higher product prices.

The main economic concern from the current covid19 lockdowns in China is supply chain bottlenecks that could lead to delays in shipment delivery.

When companies cannot get their supplies in time, they experience shortages, and the market may run for their products. This usually leads to higher product prices, hence higher inflation.

Lastly, the persistence of environmental, social, and corporate governance (ESG) proponents to rapidly switch from carbon-based energy sources to renewables is causing fewer investments in carbon-based capacity while the renewables aren’t growing at a matching pace.

This has led to a squeeze in energy prices causing a new type of inflation largely described as “greenflation”. This refers to a spike in prices and demand for raw materials used to make solar panels.

Rufas Kamau, is a Research & Market Analyst at Scope Markets Kenya