• Stocks tend to perform slightly worse during stagflation, but the difference is not significant. Large gains are rare, but there is no need for pessimism. Staying invested often pays off in the long term.
• A good stock market year during stagflation does not require a crash or interest rate cuts beforehand, which gives investors hope.
• Sector returns vary greatly between stagflation periods.
• Stagflation increases the differences between companies. Companies with strong balance sheets and pricing power are at an advantage. This offers opportunities for active investors.

Fears are rising that the global economy could be heading in a stagflationary direction – one where economic growth is weak and inflation high. Increasing tensions in the Middle East and the risk of rising energy prices only add to these worries. On average, this is the worst kind of environment for the stock market. But investors need not panic. Our analysis shows that stocks often perform well when there is stagflation, just not as well as at other times.

Importantly, there has been divergence in sector performance in these environments and performance between companies is likely to rise, too. There is an argument that the sector allocation of European stock markets could benefit them relative to the US. This would be problematic for many investors, given that the US dominates the global market.

Why does stagflation present a challenge for companies and investors?

Low growth is bad for sales, as businesses and consumers tighten their belts. Demand is weak. High inflation adds to the headache. In a buoyant economy, companies can pass on higher input costs to consumers. When demand is already weak, this isn’t so easy. Corporate profit margins often take a hit instead, putting additional downward pressure on earnings.

The ability of central banks to stimulate demand by cutting interest rates is also hampered. When inflation is high, they typically want higher interest rates to bring inflation under control, not lower. And higher rates risk making the “stagnation” worse. But if they were to cut rates, that risks sending inflation even higher.

How do stocks perform during stagflation?

In this analysis, we have defined stagflation fairly simplistically: real gross domestic product (GDP) growth below the previous 10-year average and Consumer Price Index (CPI) inflation above its 10-year average. By keeping things simple, we can analyse market performance over the past nearly 100 years. When it comes to analysing sectoral performance, we cover the period since 1974.

As could be anticipated, stocks often find the going tougher during stagflation years compared with other environments. Based on data since 1926, the median yearly real return in a stagflation year has been about 0%. This is less than investors would typically want from equities over the long-run, but it still means returns have been in line with inflation. In addition, in about half of these years they generated a positive real return – and, when these real returns have been positive, they have tended to be strong, averaging about 16%. In the interests of balance, it is worth pointing out that when they were negative, they averaged -14%.

When assessed relative to cash, equities come out better, outperforming cash more often than not (in 10 of the 17 stagflation-years). This may be a riskier than normal time for stocks, but it can also be a risky time to sit in cash. Furthermore, statistical analysis of how stocks have performed relative to cash in stagflation-years compared with the rest of the time indicates there is no significant (in a statistical sense) difference. In other words, any difference could be due to random noise rather than a meaningful relationship.

Do we need an earlier crash or rate cuts for stocks to do well during stagflation?

It is worth asking if there are economic and market conditions that have been necessary to support equities in these more favourable outcomes. The number of stagflation-years when a positive real return was generated was small, at only eight (1967, 1971, 1975, 1979, 1980, 2006, 2007, 2009), so we need to be highly wary of making bold claims. But that is not the aim here. The data shows that, even in this small sample, there have been a diverse range of backdrops that still allow for some conclusions to be drawn:

• It isn’t necessary for the market to have fallen the year before i.e. the good performance being a rebound. In most cases, it followed a year when real returns were positive (second last column in Figure 2)
• It isn’t necessary for interest rates to be cut. We assess this by comparing cash returns with the year before (a lower figure implying rates were cut). In 1979, 1980, 2006 they were raised, and in 2007 they were broadly flat (final column in Figure 2).

In short: equities can perform well during stagflation even without a prior correction or lower interest rates – although the risk remains elevated.

Do some parts of the market perform better than others during stagflation?

Sectoral data is only available since 1974, and that reduces the number of stagflation-years we can analyse. In addition, sectors themselves have changed a lot over time. Communications services used to be telecom companies, such as AT&T, whereas today Alphabet (Google) and Meta combined make up nearly two-thirds of the sector on a market capitalisation basis.

There are also important differences compared with past episodes of stagflation. In particular, the cause of high inflation in the past was often rising commodity prices but, this time round, ample supply and weak demand had left them low before the recent rise in Israel-Iran tensions. It is tariffs that were the immediate source of inflation risk.

Any conclusions from historical analysis must therefore come with lower conviction, and be overlaid with qualitative judgement. There is no historical reason why investors should expect stocks to fall, even if we do enter stagflation. There can be lower conviction of strong returns but predicting doom is not appropriate either.

Do any global stock markets have more, or less, favourable sector allocations?

When assessing this, it is important to complement historical analysis with qualitative judgement based on the current economic and market environment. The tariff shocks today are profoundly different from many stagflation experiences of the past.

The US stands out for its large allocation to the IT sector, which has historically struggled during stagflation. Its communication services behemoths, Alphabet and Meta, are also technology companies in all but sector classification. And, many of the companies in these two sectors trade on very expensive valuation multiples. Many are also caught up in the trade war, given their complex global supply chains. In contrast, the US allocations to the sectors that have performed better during stagflation are all relatively low in absolute terms (totalling 16%). The US does not look like a candidate for strong performance if stagflation becomes a reality.

On the one hand, the European market would appear to suffer from its large allocation to the industrials sector – especially given Donald Trump’s tariffs. However, Germany’s plans to increase borrowing to boost defence and infrastructure spending should support many European industrials, especially if there is a bias towards “buying European” rather than from the US. Overweights to the utilities sector and underweights to IT and communication services could also be beneficial. In principle, the financials overweight is more problematic but, as it stands today, financials are in reasonable shape and benefitting from a steeper yield curve.

Japan is weighed down by large allocations to global industrials, which are sensitive to international trade, and consumer discretionary. These sectors make up 43% of the MSCI Japan Index. It also does not have an overweight allocation to any of the sectors that one would anticipate could perform better. There are positive developments in corporate governance in Japan (moves to more shareholder friendly approaches) and valuations are outright cheap, but the global backdrop is challenging.