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I keep hearing about stagflation and how its bad for markets but could you explain what it is and why it’s potentially negative for investors?
Jane
Russ Mould, AJ Bell Investment Director, says:
When assessing the direction of monetary policy on a global basis, economists and investors have a small and confusing sample with which to work this year. A mere 10 changes in policy from major central banks to date in 2026 compares to 80 at the end of May in 2025, and this time the decisions are split evenly between five cuts and five increases, whereas the trend of a year ago is obvious, given how 63 cuts outpaced 17 hikes.
Financial markets seem convinced that the next move in interest rates will be up, from each of the Bank of England, the Bank of Japan, the European Central Bank and the US Federal Reserve, although in the case of the UK and America that represents a major switch from January when consensus was looking for two or three cuts at least.
In sum, it is tempting to argue that neither central banks nor financial markets know what is coming next. This is totally understandable, as it is easy to argue that inflation, deflation or stagflation could all yet be the ultimate result of tariffs and trade disputes, military conflict in Eastern Europe and the Middle East, an oil price shock, high levels of sovereign borrowing and poor demographics in the West and the potential impact of Artificial Intelligence and agentic agents upon jobs and pay.
This, that and the other
In general terms, the possible outcomes are as follows:
- Inflation means the price of goods and service rise, possibly sharply, as demand outstrips supply. The economy may be running hot, and nominal GDP growth may be rapid, and higher than the central bank base interest rate. The Austrian school of economics argues that inflation is always the result of growth in the money supply as central banks run policy too loose for too long. Either way, the result is that money loses its purchasing power and one unit of currency is able to buy less over time, thanks to higher prices. (There is also the dream scenario of a ‘Goldilocks’ economy, where growth jogs along, inflation stays around central banks’ 2% target and interest rates stay low, to the benefit of all. This is what we saw in the 2010s).
- Deflation means the price of goods and services fall over time (disinflation means they rise, but more slowly than before). This usually means demand is weak or supply is strong, or both. Weak demand can result from wealth destruction owing to malinvestment in the prior upcycle, a financial crash, excessive borrowing or higher interest rates, and a major economic slowdown or recession is a likely outcome. Austrians will again point to money supply, although a reduction in it on this occasion. The result here is money’s value is enhanced relative to that of goods or services.
- Stagflation is the worst of both worlds: rising prices but little or no economic growth thanks to weak demand, rising unemployment, and limited wage increases. Whereas central banks can in theory rein in inflation by tightening monetary policy, with higher interest rates and modest growth in money supply, and beat off deflation by loosening policy to boost demand for the credit that can fuel investment and spending, stagflation leaves them between a rock and a hard place. They want to raise rates to beat inflation but cut them to boost employment and growth.
Portfolio playbook
From the perspective of investment portfolios, each outcome has potential implications for asset allocation strategies across the major options of equities, bonds, real estate, commodities, cash, and alternatives (such as collectibles, cryptocurrency, and the like).
Inflation is likely to lead to strong nominal growth in GDP and corporate profits, to the potential benefit of share and commodity prices, unless the economy overheats to such a degree that companies cannot match cost increases with price increases, to the detriment of margins. Overheating could also force central banks to jack up interest rates to levels so high that corporates and consumers keep cash in the bank, stop spending and investing and the economy finally cools.
Deflation is likely to lead to recession, falling corporate profits and dividend cuts. This is likely to be bad for equities, commodities and real estate, let alone collectibles, but can highlight the value of the fixed coupons on bonds and any returns from cash.
Stagflation is tricky. Rising prices but weak demand will hurt corporate profits and thus share prices, while inflation will erode the real-terms value of coupons from bonds and any interest gleaned from cash or cash equivalents. Interest rates are likely to rise, as central banks take the view inflation is the bigger long-term danger, to pose a further challenge to equities.
Only investors can judge for themselves which scenario is going to play out, why and how financial markets may respond, but the best policy may be to prepare for multiple outcomes, not just one, with a balanced portfolio across a range of asset classes.
No-one could have predicted the war in the Middle East, and no-one can yet fathom how it ends and what any peace deal may mean, but the ramifications could be considerable, as the oil price shocks and stagflation of the 1970s suggest. Bonds and cash were terrible investments in that decade, shares fell initially and then rallied but did poorly in real, inflation-adjusted terms over the decade and only gold really shone.
Russ Mould: Investment Director
Russ Mould is AJ Bell's Investment Director. He has a Master's degree in Modern History from the University of Oxford and more than 30 years' experience of the capital markets.
He started out at Scottish...
