A recession is a period in which a country's economic activity shrinks for at least two consecutive quarters and economic growth turns negative. During this time, production falls, unemployment rises, and people's demand for spending drops.
How financial markets respond to an ordinary recession
The stock market falls sharply, because company earnings decline and bankruptcy risk rises. Government bonds become attractive and rally, because central banks cut interest rates to rescue the economy. Gold sees demand as a safe haven against economic uncertainty and usually rises. Oil and industrial commodities crash hard, because factory shutdowns destroy demand for energy and raw materials. Cryptocurrencies fall at the start of a recession due to a drop in risk appetite, but as soon as money printing and interest rate cuts begin, they enter a new bullish cycle. The important point here is that in an ordinary recession, prices and inflation come down along with falling demand, and the central bank's tools for confronting it remain clear and effective.
Stagflation: the central banks' nightmare
Stagflation is a rare and far more dangerous condition in which recession, high unemployment, and severe inflation occur simultaneously. In stagflation, the central bank's hands are completely tied: if it cuts interest rates to cure the recession and unemployment, the fire of inflation grows more intense; and if it raises interest rates to put out inflation, unemployment jumps and the recession deepens. This contradiction leaves policymakers unable to make any correct decision, and the economy stalls in a quagmire for years, as happened in the crisis of the 1970s. In stagflation, holders of cash and fixed-rate bonds, along with ordinary company stocks, suffer the greatest damage, while hard assets like gold and essential commodities become the main haven for capital.
Building a portfolio resilient to stagflation
In stagflation, common investment strategies like the traditional 60% stocks / 40% bonds formula fail completely, because stocks fall due to the recession and bonds fall due to inflation, at the same time. Gold and precious metals are the cornerstone of a defensive portfolio, because they carry neither the risk of a company going bankrupt nor the risk of being devalued by money printing; in the 1970s, gold posted one of the best returns in its history. Investing in commodities and energy also makes sense, since the jump in energy or food prices is often itself the main cause of the inflation. Defensive-sector stocks like essential consumer goods, utilities, and pharmaceuticals are also a good choice, since people are forced to buy from them even in the worst economic conditions. Inflation-linked bonds (TIPS) adjust the principal in line with the inflation index, and part of a portfolio can also be held as short-term cash to take advantage of staged buying opportunities. Real estate, as a physical asset, also grows alongside inflation. And finally, Bitcoin has high potential due to its anti-inflationary nature, but because of its dependence on overall market liquidity, it experiences severe volatility in the early phases of a recession; so allocating a small percentage of a portfolio to it as an upside option makes sense, rather than making it the portfolio's main weight.
In stagflation, the main goal is preserving your principal and preventing a loss of purchasing power, not chasing sky-high, risky returns; a portfolio built on the pillars of gold, energy, defensive and pharmaceutical stocks, and inflation-linked bonds will have the greatest resistance to this economic anomaly.