Investing in Case of Stagflation [It could happen again]

Morningstar.com ^ | Friday November 18, 6:00 am ET | Michele Gambera

[BenLurkin]

In a previous commentary, I discussed three macroeconomic scenarios that could affect the markets in general and long-term bonds in particular. These are just three of many possible scenarios that may happen in the future. I did not assign any probability to the scenarios but only showed things that occurred in the past and that, in some different form, may re-emerge in the future. In this article I would like to look at another possible scenario that some readers suggested: stagflation and a sustained boom in commodity prices.

Stagflation is a recurring topic when the economy is growing slowly or not at all and people feel gloomy. In the 1970s, U.S. companies were inefficient and unable to keep up with the high quality and variety of foreign goods. Two oil shocks and loose monetary policy triggered inflation, which was unusual for a recession: Inflation generally appears when aggregate demand is too high, exactly because the supply of goods and services cannot keep up with growing demand. Instead, stagflation, the sum of stagnation and inflation, appeared in many developed countries. Policymakers did not know what could have helped the situation. Eventually it ended, but at the cost of a painful readjustment.

Stagnation... What could cause stagflation again? Let's start with the stagnation component. U.S. consumers have been spending beyond their means thanks to second mortgages and relatively easy credit: If they ceased borrowing any further and reined in their spending, we could see a significant slowdown.

Similarly, the U.S. federal government along with some local governments have been running deficits, spending more than they collect in taxes and other revenues. A tax reduction when a deficit is present is a loan the government takes from your children and passes to you. While it is logical to borrow money from future generations to invest and leave them with a cleaner, safer, and more productive world, it may be counterproductive to borrow from them to finance consumption, unless it is for a very limited time. What if the future generations (and the rest of the world) stopped lending us money? That is, what if the U.S. trade deficit, which is the result of consuming more than we produce, had to be reduced, perhaps using a large devaluation of the dollar? Could households and governments live more within their means without triggering a crash in aggregate demand? Would real estate prices fall?

Plus Inflation... As for inflation, energy and basic-material prices have been rising, due in part to sustained demand from emerging economies. Can the U.S. at least partially free itself from the economic and political yoke of elevated energy consumption and therefore damp the effects of resource price peaks? Probably not. Besides, the dollar devaluation I mentioned earlier would make imported inputs even more expensive.

In addition, an accommodating monetary policy has allowed growth in asset prices, particularly real estate. In turn, this enables households to finance consumption by borrowing more and more, leading to further inflationary pressures. Perhaps bank supervisors, including the Federal Reserve and the Comptroller of the Currency, should discourage banks from offering creative mortgages and second lines of credit to borrowers who already have a lot of debt. In any case, the accommodating monetary policy of the Greenspan Fed may already be leading us into an inflationary period.

Economists Robert Barsky and Lutz Kilian suggested that stagflation in the 1970s was caused more by imperfect monetary policies than by oil shocks. It is interesting that in a comment to this article, Ben Bernanke, recently nominated to succeed Alan Greenspan as chairman of the Federal Reserve Board, wrote that "Monetary policy contributed to the oil price increases in the first place by creating an inflationary environment in which excess nominal demand existed for a wide range of goods and services. . . . Without these general inflationary pressures, it is unlikely that oil producers would have been able to make the large increases in oil prices 'stick' for any length of time." Therefore, we can expect Chairman Bernanke to focus on all components of CPI, including core inflation and commodities. He may not see asset price inflation as his main problem, as he mentioned in April 2004 at a meeting of the CFA Society of Chicago.

Equals Stagflation Hence, the case for stagflation as an extreme but plausible scenario exists. A collapse in internal demand together with a dramatic fall of the dollar and upward pressure on prices may happen.

Should you invest in commodities and precious metals to shield yourself from the risk of stagflation? That's ultimately for you to decide, but I will say that sustained increases in input prices should lead firms toward more efficient technologies, thus reducing demand for such inputs in the long run. Therefore, you should consider whether investing in commodities is a diversification play or simply chasing past performance, which, as we know, can often be a losing proposition. (Think of those who bought gold at $850 when it peaked in January 1980.)

Purely for diversification purposes, some exposure to those areas makes sense. Confusingly, the several indexes that track commodity performance are built differently and give sharply conflicting results. For example, some indexes include gold and some do not. Rian Akey of Cole Partners, a consulting firm on alternative investments, points out that the correlation among investable commodity indexes may be as low as 59%. Moreover, as argued by many authors, including yours truly, in forums such as the Journal of Performance Measurement and the Journal of Alternative Investments, traditional measures of risk-adjusted performance such as the Sharpe Ratio are ill suited to asset classes, such as commodities, with skewed return distributions. The Morningstar Rating, by the way, can handle return skewness.

I might suggest you start by looking at Morningstar's Fund Analyst Picks in the categories of precious metals and natural resources. Morningstar's analysts can guide you through the risks, but also the potential diversification benefits, of such stagflation-friendly investments

[BenLurkin]

i don't know for a fact but I suspect this author is too young to actually remember the 70s and all that contributed to stagflation.

Conservatives have long held that deficit spending was -- long term -- a cause of inflation. Unfortunately this naive writer puts the taxation cart ahead of the spending horse.

An interesting article nonetheless.

[Pete from Shawnee Mission]

Thanks for the post.

Demand from China and India will, I believe, keep natural resource and energy stocks the place to invest for at least the near future. If you invest at gold at the right time you can make a killing within a year--or lose a ton.