Rising risk of Stagflation

Posted By Darren Winters on Feb 20, 2018


Rising risk of Stagflation

Could a rising risk of stagflation, which is defined as a troubling combination of high inflation, declining consumer demand and high unemployment (or decline workforce participation rate) be real?

If last week’s official economic data from the US is more than a temporary blip and a growing trend then the worse type of inflation, stagflation could be dead ahead.

Rising risk of StagflationThe official narrative goes something like this. The world’s largest consumers are not consuming like they use to. Indeed, US January sales were down 0.3% which represented their biggest drop in nearly a year. US Households cut back on purchases of motor vehicles and building materials.

Declining household demand is following another trend; rising credit-card delinquencies and bankruptcies. So households (and many small businesses) are tapped out.

Put another way, the borrowed “recovery” has run aground. A higher level of household debt is unsustainable, which means tomorrows consumption can’t be sustained with more debt today.

But lackluster or declining demand typically follows deflation (falling prices) which was the wall of worry for financial market a few years ago. However, January’s CPI jumped 0.5% which was well above market expectation of 0.3%.

So how can there be a risk of inflation (stagflation) when household demand is falling, bearing in mind that falling demand usually (logically) leads to declining prices as businesses try and entice consumers to spend?

Hidden-inflation around the corner explains why I believed that “this (look the other way) there is no inflation to worry about doesn’t tally. Rates could rise faster in 2018 then what most market watchers are forecasting,” I wrote.

The reason for rising risk of stagflation is straightforward. Put simply, in any given economy there exists a finite amount of resources producing a finite amount of goods and services. Meanwhile, the fiat money supply is infinite. Moreover, the post-financial crisis of 2008 the major central banks have created nearly 12 trillion dollars of fiat currency to keep asset prices propped up. But the value of fiat currency is based on its exchange value for goods and services.

So if the system is flooded with cash and it creates a boom in speculative activity but no productive activity that will have little or no impact on the availability of goods and services in that economy.

More cash chasing finite resources (skilled labor, commodities) will result in input prices rising, hence the rising risk of stagflation (rising prices and falling output).

The side effects of the central bank’s massive monetary easing policy are visible, apart from creating asset bubbles it has also debased (depreciated) fiat currency.

Bitcoin, cryptocurrency’s stellar price rise underscores the depreciation of fiat currency. Bitcoins price is rising because fiat currency is depreciating due to the central bank’s massive money creation But cryptocurrencies (outside the central bank system) will most likely be taken down, regulated into oblivion See Where next for Bitcoin?

Moreover, if price discovery were real precious metals would be a lot higher too.

So the market finally gets wind of a rising risk of stagflation (read this blog and you are ahead of the herd) and bond yields are rising. The US Treasury 10 Year Note is on the cusp of a technical breakout of 3% yield. Bond yields are inversely related to their price. Already the US10Y is above its long-term downtrend when it rose above 2.64%.

Fixed long bond yields become less attractive as investors think why keep funds parked in fixed yields when a better return on capital can be earned in a cash deposit account with rising interest rate payments. So as investors flee bonds, price falls and yields rise.
But the downtrend in yields is also bad news for equities. See this chart.

Rising bond yields and interest rates increase the cost of servicing debt which also eats into corporate profits.

However, regarding stock prices, the above is assuming that the fundamentals still count.
Remember the Insane Rule where bad economic news is good news for stock prices because it implies that the Fed will continue with a monetary stimulus policy (more quantitative easing and near zero interest rate policy).

Last week’s economic data showed a negative divergence between consumption, inflation and a rising risk of stagflation. Within the first hour of the news, stocks tanked and a bear market trend would have been confirmed.

But the New Fed Chairman Jerome Powell showed his hand and stock soon rallied. Powell will follow the Fed mandate of keeping markets stable with more QE, even though he has expressed his doubts about QE in the past. So bad economic news could be good for stock prices going forward. My two cents worth is that the Fed will probably unwind their massive balance sheet if and when the economic fundamentals improve. This will give the Fed the slack to unwind as retailers and institutions pile in to take the other side of the trade.

But if there is a rising risk of stagflation, similar to the 70s, how then can investors make their portfolios stagflation proof?
Let’s go back to the 70s and take a snapshot of how different asset classes performed. Take a look at this graph here.

The top-performing assets were Commodities, pharma, copper (metals) and cash. Shares, small caps (risk assets) provide the worse returns during 1969-73. So it is no surprise that commodities Blomberg commodity index is currently near its 52 week high.

If the rising risk of stagflation is real then Stagflation proofing your portfolio could mean stocking up on commodities, pharmacy, metals and have a bit of cash on the sideline too.

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