Articles - What does stagflation mean for equity investors

By Duncan Lamont, Head of Strategic Research, Schroders

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.

As well as the well-trodden valuation argument, this is one more reason why we believe investors should be wary of passive approaches to investing in global equities today.

As well as weakening corporate fundamentals, 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, then that risks sending inflation even higher. There are no easy options.

We compare using 10-year averages rather than fixed rates of growth and inflation because what will have felt like low growth or high inflation to investors isn’t constant over time. It depends on what they will have been used to. This is a less severe definition of stagflation than those that require there to have been a recession (negative growth).

As could be anticipated for the environment described above, 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 getting close to inflation in a high inflation environment is not a bad outcome. 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%.

Figure 1: Equities perform well in around half of stagflationary environments, worse than others but should not be ruled out

US real equity returns when inflation and growth are above/below their 10-year average, 1926-2025 calendar year data (number of occurrences in brackets).

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.

It is not 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 is not 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).

Figure 2: Positive (and negative) real returns during stagflation are not conditional on prior year market performance or rate cuts

Calendar years when inflation was above, and growth below, their 10-year averages, 1926-2025.

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.

Figure 3: Sectoral performance is mixed during stagflation

US sectoral real equity returns when inflation is above and growth below its 10-year average, 1974-2025, calendar year data.

Figures are shown on a rounded basis. Based on analysis of data on sectors of the US equity market 1974-2024. Calendar years shown are those where both real GDP growth was below the previous 10-year average and CPI inflation was above its 10-year average. Based on Datastream US sector indices. Source: LSEG Datastream and Schroders. Past performance is not a guide to the future and may not be repeated.

While many of these are intuitive, it is important to again highlight the small sample size. When we run statistical tests (see Appendix), the only sectors where performance comes out as significantly different during stagflation-years are the materials and financial sectors.

Figure 4: Regional market composition

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. In contrast, the US allocations to the sectors that have performed better during stagflation are all relatively low in absolute terms (totalling 15%). 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. Europe has also been very publicly in the firing line for President Trump's tariffs. However, Germany’s plans to increase borrowing to boost defence and infrastructure spending should support many European industrials, especially given the 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. This will be a sector to keep an eye on.

The UK, a market which has been unloved by global investors for many years, is also an intriguing proposition. Its 16% allocation to the defensive consumer staples sector and 10% to energy are more than double any other major market has to either. Plus, it has barely any exposure to the IT or communication services sectors compared with elsewhere. Like Europe, the UK is overweight financials. While not without risk, there is definite potential for negative perceptions about the UK market’s boring, defensive, nature to turn to its advantage. It also remains cheaply valued compared with overseas markets and therefore has a more favourable starting point.

Japan is weighed down by large allocations to global industrials, which are sensitive to international trade, and consumer discretionary. These sectors make up 44% 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 relatively cheap, but the global backdrop is challenging.

Sector allocations are also not particularly favourable for emerging market equities, with overweights in consumer discretionary, communication services and financials.

Whichever market you look in, there will be winners and losers. Sector allocations can provide useful insights into potential risks but it is only by analysing individual company fundamentals that investors can hope to identify those which have the potential to thrive and those which risk underperforming.

Stocks perform worse during stagflation than at other times, but the difference is not statistically significant. Historically, they have outperformed cash and kept pace with inflation. There can be lower conviction of strong returns but predicting doom is not appropriate either. There is always a reason to worry and long-term investors are likely to benefit from staying invested.

Good performance in stagflation is not dependent on the market having fallen beforehand i.e., a rebound. Nor are rate cuts a necessary ingredient. This should provide some comfort to equity investors today.

Performance during stagflation varies a lot between sectors, and across historical episodes. Although, statistically, there is insufficient data to draw firm conclusions, we can add to that with qualitative judgement and intuition. On this basis, the US and Japanese markets look negatively exposed to stagflation risk. Europe and the UK are more interesting propositions. Investors passively tracking the global market could find this uncomfortable, given the MSCI World Index has 70% in the US and MSCI ACWI has 62%. Stagflation could encourage the broadening out trend seen so over 2025 and early 2026 to continue.

While we have not analysed individual company financials within this article, it should be obvious that there will be increased variation in performance at the company-level should we enter stagflation. Balance sheet resilience and pricing power will be important. As correlations among stocks fall and dispersion in returns rise, the potential for active managers to add significant value should rise with it.