Inflation is soaring right across the globe, and investors are worrying about the state of the global economy as central banks aggressively hike interest rates.

It might seem like unfamiliar territory to many investors, but there are some parallels being drawn with the stagflation' era that lasted nearly a decade starting in the 1970s.

The concept of stagflation is enough to send a shiver down the spine of more experienced investors who have been in the game for decades. But what should new investors make of the current global economic environment? Could we be looking at a period of stagflation ahead?

What is Stagflation?

Let tackle the basics first. 

Stagflation is an outcome in the economy that describes low growth and high prices. The name comes from the fact the economy enters stagnation, while inflation drives consumer prices higher.

That means there are two, if not three, components to stagflation that occur simultaneously.

• High inflation

• Slowing economic growth - and high unemployment

Global inflation has been driven higher by a number of factors, from government stimulus, to supply chain constraints, surging energy prices, and even the fallout of the war in Ukraine. 

If you need a recap on inflation, read more here.

When the economy stagnates, unemployment tends to increase. Historically, higher unemployment is at odds with periods of higher inflation, as the two factors were seen as inversely related. This is due to the nature with which rising wages in a fully-employed job market can spark inflation if businesses pass on these costs. 

In other words, high inflation was traditionally tied to periods of low unemployment, and vice versa. 

This all changed in the 1970s when both inflation and unemployment were increasing at the same time. It occurred on a global level, but Australia unemployment rate exceeded 10%, and the local inflation figure trended at an average rate of 11.6% for a decade.

Why is Stagflation a Risk to the Stock Market?

The inflation component of stagflation means that central banks need to look at ways to address rising consumer prices. This means hiking interest rates to lower inflation.

However, there is a risk to this approach. When central banks pursue an aggressive rate hike cycle, they run the risk of crippling economic growth altogether.

If we consider some of the dynamics at play, stagflation has the potential to prompt a rethink among businesses in terms of investing for growth. After all, business sentiment takes a hit as the economy cools, and lending activity may also tighten.

Consumers, already at risk of job losses as the unemployment rate increases, grapple with high inflation pushing up goods and services. In turn, this flows through to a wide range of businesses and stocks, from lenders and their loan books, to retailers, property operators, leisure operators, and other consumer discretionary names.

With these factors in play, there is the immediate risk that stock valuations become stretched as the outlook for corporate earnings growth may start to wane with the economy in stagnation.

The biggest risk of all, however, is if the above forces tip the economy into a recession. If this appears likely before central banks have tamed inflation, policy makers are then caught between a rock and a hard place. 

Has Stagflation Arrived?

At the moment, the economies of both Australia and the US have yet to reach a stagflation scenario. But remember, the economic data we have at hand is delayed, so it remains to be seen whether both economies can escape a repeat of the 1970s. 

While inflation may be soaring in both countries, and other regions for that matter, the job market in both regions is still running hot. Yes, growth has shown signs of being anemic - US GDP growth even slowed in the first quarter of 2022 - but unemployment is sitting near record lows.

With the stock market often focused on the future, rather than the here and now, it no wonder some investors have turned their attention to whether stagflation might be on the horizon.