When it comes to inflation, time is not on our side. The longer a bout of inflation lasts — and the more volatile it is — the more likely it is to become ingrained into society’s collective psyche, which increases the risk of stagflation1 setting in. 

Heading into 2022, we viewed stagflation as a relatively low risk given the strong growth momentum seen across much of the world. However, the ongoing conflict in Ukraine and subsequent sanctions against Russia have led to further upward pressure on commodity prices. The resulting mix of higher inflation and lower growth have raised the risk of stagflation for the medium term, although it is far from our base case of lower, yet positive, global economic growth and inflation peaking later and at higher levels.2


It is, however, a risk that will grow with time, especially if hostilities and the resulting inflationary impulse last into 2023: Careful attention will be required given how damaging it can be to investment portfolios.




The factors behind inflation’s rise began to ignite in the mid-2010s as globalization was increasingly questioned, and the US–China “trade wars” added further kindling. More capital discipline after the shale bubble in the early 2010s led to more limited US energy production relative to possible supply. Furthermore, growing environmental legislation increased the cost of energy production and consumption, in some countries more than in others. Unconventional monetary policy became acceptable and fiscal discipline became increasingly unfashionable in Western countries.


The spark


The spark behind inflation’s most recent significant spike came in 2020, when governments across the world damaged supply by incentivizing or forcing large parts of their population to stay at home for extended periods of time in an attempt to mitigate the impact of COVID-19. This lowered labor supply and disrupted supply chains, which in turn reduced overall economic output. Demand on the other hand, at least for goods, was supported through stimulus checks and other forms of assistance that were introduced by fiscal authorities with the support of central banks that monetized the debt.


It is getting hot


The combination of supply chain disruptions and excessive stimulus led to a strong rebound in growth and spending but also inflation, which reached a 40-year high in early 2022.3 While there were certainly supply issues to contend with, we can view this inflation as being at least in part growth or business-cycle related. The central bank policy response to this type of inflation is well understood by markets and, indeed, expectations of central bank tightening ramped up in January 2022. This was testing for portfolios, for both fixed-income and risk assets, but represented traditional, business-cycle-related patterns well understood by market participants. Our own expectation was for inflation to fall over time to close to — while remaining modestly above — central bank targets. This would, in turn, provide a form of light financial repression policymakers seem to have deemed necessary, given the debts accrued during COVID-19.


Adding more fuel


This was disrupted, however, by Russia’s invasion of Ukraine and the subsequent sanctions imposed on the aggressor nation by Western countries, as we have explained in more detail in separate papers.4 While Russia does not have an outsized presence in financial markets, it is a key exporter of several commodities, as shown in Figure 1 above. Adding in Ukraine, a major producer of wheat, only exacerbates the situation.

Figure 1. Russia’s share of global commodity production 

Source: Morgan Stanley research, Goldman Sachs, JP Morgan, Haver, Woodmac. As of 2020. Ukraine’s share in global supply for wheat and corn is 7% and 22%, respectively (Morgan Stanley, IHS Markit, Goldman Sachs).

Sanctions and the conflict itself are now threatening some, if not all, of this commodity supply. This comes at a time when global supply chains are still trying to recover from the pandemic fallout and still face regular setbacks.5 The result on commodity pricing to date can be seen in Figure 2. This kind of commodity shock not only represents “bad” inflation from the perspective of consumers and commodity-importing countries, but also raises the spectre of stagflation.


Rising commodity prices have both direct and indirect impacts on consumers and the broader economy. Using energy as an example, higher gasoline prices affect us directly at the pump but also have a range of other ramifications, from increasing the expense farmers bear to bring in the harvest to bumping up the cost of delivering online orders to our doorsteps. The results shift an economy’s supply–demand curve toward lower production and higher prices.

Figure 2. Commodity price changes since the onset of hostilities


Source: Refinitiv, Bloomberg. Performance between February 23, 2022, and March 18, 2022.

We can already see this in economists’ forecasts and market prices: Consensus economic forecasts for the first half of 2022 have already been downgraded by some economists, the brunt being borne by Europe and Russia, while inflation expectations have been on the rise. Although we do not appear to be in stagflation quite yet — economic growth is still expected to remain positive for 2022 according to most forecasters, thanks to strong momentum heading into the year — it can no longer be dismissed as an unlikely tail risk. The longer hostilities run in Ukraine, and commodity prices remain elevated, the greater the likelihood of stagflation.


Examining financial market performance year-to-date, we also see some stagflation risk being priced in. Gold has risen by around 6%, the Bloomberg Commodities Index is up 24% and the S&P Global Natural Resources Index6 is up 12%. Most equities, such as the MSCI All Country World Index, are still deep in the red, if not correction territory, as is the case for NASDAQ. Global nominal government bonds are down by almost 3% and global credit is down by 4%.7


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Gold has risen by around 6%, the Bloomberg Commodities Index is up 24% and the S&P Global Natural Resources Index6 is up 12%.
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As a reminder, the last time a geopolitical event had such a massive, sudden impact on commodity markets was during the Arab oil embargo in 1973. We have already seen the biggest weekly gain for commodity prices ever recorded during the first week of March and the three-month rolling performance is edging ever closer to the record set in the summer of 1973.8 However, we are not advocating for naively extrapolating from the 1970s. The flow-through mechanisms are different. Indexation of wages — both formal and informal — is far from standard, at least at the moment in major developed countries. Although inflation expectations have risen recently, they were lower and more stable going into the current shock than they were in 1973. At the same time, energy intensity has declined.9 The creation of the US Strategic Petroleum Reserve in 1975 provides an additional cushion.10 Those factors could mitigate the inflationary impact on the economy.


On the other hand, looking at markets, the 1973 oil price shock was not accompanied by risk assets at multi-decade highs and rates at multi-decade lows. Even after the drawdown seen in the first quarter of 2022, equity valuations as measured by the CAPE ratio are still at the second highest level ever recorded.11

Hope for (but don’t count on) a bucket of cold water


If peace between Ukraine and Russia were to be agreed, then markets would likely regard recent events as just another short-term geopolitical blip, even if they have had a devastating humanitarian impact. Unfortunately, we cannot afford to be so complacent. Even if the conflict ultimately ends — which we hope will happen quickly — the prospect of sanctions on Russia being lifted soon thereafter, and its commodities returning fully to world markets, would be remote. Of course, this does not mean commodity and oil prices will have to automatically increase significantly from here, but it is a possibility.12


Exploring this less benign scenario of commodity prices remaining high or going higher, central banks would be faced with two unattractive options:


1. Raise rates/tighten financial conditions sharply, resulting in a sharp recession in a bid to fend off stagflation; or


2. Be more cautious in raising rates and risk stagflation taking hold.


Starting with Scenario 1, in a monetary-policy-driven recession with an inflation kicker, both risk assets and bond duration would be expected to suffer initially as rates are hiked beyond what is priced in already. Duration would be expected to eventually recover to a degree, given that inflation might fall, but the recovery for risk assets would be expected to be slower as rates are unlikely to be as supportive as in past recessions. Not many assets would be expected to do well in a scenario of rising real rates and slowing growth. Gold comes to mind as one which might — as the ultimate “fear asset,” it can be negatively correlated with equities and could mitigate the shock to a growth-asset portfolio, to a degree. However, gold prices are also sensitive to real rates and thus vulnerable if central banks are too “successful,” as rising nominal rates and falling inflation would put upward pressure on real rates. Holding cash would be another option: It would not give real returns but likely hold its own and become a source of liquidity when opportunities begin to arise. Short-duration or floating-rate credit, as well as tail-hedge strategies, could also be considered.



Moving to Scenario 2, stagflation, which had long been viewed as a tail-risk scenario, has now turned into a more tangible threat. If central banks choose to follow wage inflation and “look past” the spike in commodity prices, inflation could eventually spiral out of control as central banks chase a lagging indicator. 


In practice, this is a two-part scenario: If central banks are too cautious at first,13 worried about pushing the economy into recession, they might allow stagflation to take hold and then double down as described above in a Paul Volcker14-style extinguishing of the inflation fire at a huge economic cost. When testifying in early March,15 Federal Reserve chairman Jerome Powell explicitly confirmed that he might follow Volcker’s example.


There are few asset classes that do well in a stagflationary scenario. Growth assets such as equities tend to do poorly in such an environment, on the whole. Of course, some sectors and styles may do better than others — equities tied to the energy sector, for example, could be a major beneficiary as we have already seen year-to-date.16 Nominal fixed-income assets obviously suffer in inflationary regimes as their cash flows are eroded.


Inflation-linked bonds may do better if real yields fall, which is not always a given as central banks may hike rates to break inflation expectations.17 Even real assets such as property may not do that well, at least in the short term, as rents cannot be revalued instantly and discount rates will rise to allow for higher inflation expectations.


The only asset classes we believe would be expected to do well in stagflation are gold and (potentially) inflation-linked bonds, but performance for both asset classes is subject to real rates not rising too much in the late stages of a stagflationary shock. Commodities usually perform well both when inflation comes with growth and when stagflation is driven by a major geopolitical shock, as is happening at the moment.

Diversify across a range of inflation-sensitive assets to hedge stagflation risk


The key takeaway in our inflation protection paper18 was to broadly position portfolios via inflation-sensitive assets toward a number of different inflationary scenarios to improve portfolio robustness. That advice remains the same today, with a greater emphasis to position for stagflation risk — one of the scenarios for which traditional portfolios were least prepared. We would not encourage investors to reshuffle portfolios toward geopolitical events given how quickly they are evolving and note that the initial spike in commodities and gold has been missed. However, we believe stagflation remains a real risk beyond the immediate fall-out of the Ukraine conflict.


As we potentially move into a more multi-polar, chaotic and fragile world, we will all be more susceptible to future geopolitical or climate-related events. With it, the risk of outsized moves in commodity markets or other crucial inputs such as semi-conductors makes it likely that stagflation will remain more than just a tail risk. Portfolio construction needs to factor this in via a strategic allocation to gold and a commodity allocation which could be implemented via developed market natural resource equity strategies, commodity-trend strategies or commodity futures.19 Investors who do not already have these allocations need to be mindful that both gold and commodities/natural resource equities have considerably increased in value year-to-date and may have priced in elevated stagflation risk — at least to some degree. Dips in the near future may present opportunities for those investors to gradually hedge against stagflation risk in their portfolio for the long term.

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As we potentially move into a more multi-polar, chaotic and fragile world, we will all be more susceptible to future geopolitical or climate-related events.
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  1. We define stagflation as a secular period of weak growth and high inflation.
  2. Mercer. Conflict and Inflation: Global Dynamic Asset Allocation Update, March 2022.
  3. As measured by the Consumer Price Index for all urban consumers; all items in US city average. St Louis Federal Reserve and U.S. Bureau of Labor Statistics (accessed on   March 18, 2022).
  4. Mercer. Peering Through the Fog: Examining Prior Examples of the Impact of Geopolitics on Financial Markets in Light of Current Market Events, February 2022.
    Mercer. Offloading Russia: Investment Implications of Russia Being Removed From Indices, March 2022.
    Mercer. Conflict and Inflation: Global Dynamic Asset Allocation Update, March 2022.
  5. When this paper was published, China was shutting down large manufacturing hubs at Shenzhen and Changchun, which could impact semi-conductor, automobile and   other supply chains around the world.
  6. S&P Global Natural Resources Index includes 90 of the largest publicly traded companies in natural resources and commodities. Companies are in three primary   commodity-related sectors: agribusiness, energy, and metals and mining (as of March 18, 2021).
  7. Refinitiv, year to date as of close of March 17, 2022.
  8. Deutsche Bank.
  9. According to a note from Deutsche Bank published on February 25, 2022, in 2020, the amount of energy for each unit of GDP was 37% of its level in 1970. There are similar   findings for the EU (going back to 1995).
  10. Alhough this predominantly cushions the blow for the US economy, we would expect a global spillover effect if oil supply increases in the world’s largest economy. Other countries also have strategic petroleum reserves, including the UK, China, Japan, India and South Korea (accessed March 18, 2022).
  11. See Robert Shiller’s CAPE dataset (accessed March 18, 2022).
  12. After peaking at US$130 in early March, oil prices fell back to approximately US$100 in mid-March on the back of hopes for a ceasefire; the potential for additional supply   from Venezuela, Iran and US shale; and lower demand after China locked down major cities. WTI oil futures are pricing oil to stay around US$90 per barrel through   2022 and fall to US$80 per barrel by the end of 2023 (as at close of business March 18, 2022).
  13. After the Federal Reserve increased short-dated rates on March 16, 2022, for the first time since 2018, an aggressive pace of further rate hikes is currently being expected by Fed officials and priced in by markets but may still not be enough to fend off inflation in an extreme scenario.
  14. Paul Volcker was the chairman of the Federal Reserve from 1975 through 1987. Inflation had reached double-digit levels when he took office. During his tenure, inflation was brought down through a “shock” treatment of steep discount rate increases, even if that came at the at the initial cost of lower economic growth and rising unemployment.
  15. Timiraos N. “Fed’s Powell Says Ukraine War Creates Risks of Higher Inflation,” The Wall Street Journal, March 3, 2022, available at https://www.wsj.com/articles/feds-powell-set-to-discuss-rate-rise-plans-with-senate-lawmakers-11646303401. 
  16. MSCI ACWI Sector Energy has returned approximately 16% year-to-date to March 17, 2022, when the MSCWI ACWI as a whole has returned approximately -8% (Refinitiv).
  17. Outlined in more detail in our paper, Inflation-Linked Bonds: A Real Dilemma. There are also regional differences in inflation-linked bond markets.
  18. Mercer. Inflation Protection: Building Robust Portfolios, 2021.
  19. See our paper, Commodities in an Inflation-Aware Portfolio, for more details.

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