Inflation is rising and the economy is decelerating, but those problems don’t add up to that nasty combination of stagnant growth and out-of-control price increases. Yet.
Stagflation is coming. Lock up your portfolio. We could be on our way to a replay of the 1970s.
That’s the worry among an increasing number of investors as we head into 2008. It’s certainly possible for the year ahead, but it’s unlikely. In this column, I’ll look at what would have to go wrong for stagflation to return and how to position a portfolio if you think stagflation is more of a danger than I do.
The ’70s have a lot to answer for:
"Airport," "Airport 1975," "Airport ‘77" and "Airport ‘79."
The Village People and "YMCA."
The breakup of the Beatles.
President Jimmy Carter and the killer rabbit.
Sonny Bono’s bell bottoms.
And stagflation, that lethal brew of stagnant growth and high inflation.
In the United States, headline inflation started off the decade at 5.5% in 1970, peaked at 12.2% in 1974 and again at 13.3% in 1979, and didn’t drop below 4% until 1982. For the ’70s as a whole, inflation averaged 7.4% annually. In comparison, inflation in the 1960s averaged 2.5% annually.
Real economic growth tumbled. Subtracting for inflation, the economy grew by just 3.27% on average from 1970 to 1979, quite a drop from the 4.44% average annual growth in real gross domestic product recorded from 1960 to 1969. And in two years during the 1970s, after subtracting for inflation, the economy actually declined in size — by 0.5% in 1974 and 0.2% in 1975.
As you might expect, the 1970s weren’t a great time for investors. The Standard & Poor’s 500 Index ($INX) returned a compound annual 5.9% from 1970 to 1979. With inflation running at an annual 7.4%, an investor in the stock market was losing ground every year to inflation. Bond investors had it even worse: The compound annual return on a long-term U.S. Treasury bond for the decade was just 4.8%, 2.6 percentage points lower than the inflation rate.
So you can understand why the prospect of stagflation in 2008 would send shivers up investors’ spines. How likely is that scenario? Let me break down stagflation into its two parts, the "stag" and the "flation." I’ll deal with "flation" first.
The ‘flation’ part of the equation
Is high inflation coming back? Yes.
The Federal Reserve and the European Central Bank, the two most important inflation fighters in the world, are worried that inflation is too high. Headline inflation, the number the European Central Bank watches, was 3.1% in November in Europe, way above the bank’s 2% limit. In the United States, headline inflation was 4.3% in November.
The Fed’s preferred measure of core inflation — headline inflation minus any increases in volatile food and energy prices — was a lower 2.3%. (Energy prices were up 21% in the month, so leaving them out of the inflation calculation helped.) But even that was above the Fed’s comfort zone.
For the "flation" part of stagflation to set in, those rates have to go higher and create the expectation that inflation is headed out of control.
Unfortunately, higher inflation is coming from every direction you care to look. Normally, the Federal Reserve and the European Central Bank would move to stomp out inflation by raising interest rates. Now, thanks to a weakening U.S. economy and turmoil in the debt markets, the Fed is lowering interest rates instead, and both banks are flooding the financial markets with short-term cash.
China, Russia and other emerging-market economies determined to keep their currencies from gaining against the dollar are creating money to buy dollars, inflating their own currencies, and that money is fueling booms in stock and real-estate markets. Inflation hit 6.9% in China in November, for example. And these countries are exporting some of their inflation in the form of higher prices for developed-world customers such as Wal-Mart Stores.
Demand from these fast-growing economies for raw materials is driving up the price of coal, iron ore, corn, wheat, oil — just about every commodity you can name. A falling U.S. dollar is driving up the cost of everything the country imports, from oil to children’s toys.
Normally, the Federal Reserve could count on a slowing economy to take a bit of wind out of inflation’s sails. But many of the current causes of inflation aren’t linked to the U.S. economy. We could get inflation and slower growth — the definition of stagflation.
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