Stagflation Revisited

    In April 2007 I wrote an article for the Roundup titled “What Exactly Is Stagflation?” At that time our economy showed early signs of stagflation. It is time to revisit that article because stagflation has been confirmed.
    Stagflation is a combination of stagnation and inflation. Stagnation is recession, a slowing economy. Stagnation refers to an economic period of very little or no economic growth. Specifically, stagnation refers to economic growth of less than two to three percent annually. While we do not benefit from a booming economy during times of stagnation, neither do we pay more for goods and services.
    Inflation, on the other hand, refers to a sustained increase in the overall prices for both goods and services. As inflation rises, it takes more dollars to purchase goods and services. The value of the dollar is noted in terms of purchasing power. During inflationary times, purchasing power falls dramatically.
    Stimulating the economy – lowering taxes to put more purchasing power into the consumer’s hands – treats stagnation. Don’t raise taxes, Barack! As these dollars move through the system, more goods are produced to meet the needs of consumers with dollars to spend. More jobs are created to produce the additional goods and services demanded, and as employment rises, wages also increase.
    Inflation becomes a problem when demand for goods and services outpaces production of those goods and services. There are too few goods on the market for the number of consumers. Thus, prices rise. Chinese and Indian economic growth is putting pressure on the world’s supply of raw materials and commodities creating problems such as our higher fuel costs. It is the basic law of supply and demand, with supply on the low side and demand on the rise. Inflation hits fixed income investors the hardest.
    What is an economist to do? If our government lowers taxes and places more money in the hands of the consumer to purchase additional goods and services, they have decreased our chance of stagnation. However, placing more dollars in the hands of the consumer to compete for goods and services when demand is outpacing production means that inflation will soar.
    Stagflation describes a period of high price inflation combined with a period of slow economic growth, high unemployment and even recession. “Stag” refers to a sluggish economy combined with “flation” referring to rapidly rising consumer prices.
    Fiscal and monetary policies used for directing economic growth either slow growth to reduce inflationary pressures or allow an increase in price of goods while generating higher production. Stagflation creates a policy nightmare because efforts to correct one problem increase the other.
     The Federal Reserve can stimulate the economy and create jobs by lowering interest rates and thus increasing money supply, allowing consumers to demand more goods and services. But this increases the risk of inflation. They can pursue a tighter monetary policy by raising interest rates to reduce inflation, but this increases the risk of high unemployment and slow economic growth. At some future point, our Federal Reserve will have to raise interest rates to curb inflation.
    The best fiscal policy for stagflation is not clear. One idea is that government should stimulate growth through lower taxes and increased spending while the Federal Reserve raises interest rates to fight inflation. Coordinating fiscal and monetary policies through different agencies might be tricky. Another theory suggests this problem is the result of excessive government regulation. In this case, it has been suggested that monetary policy might continue to regulate inflation while deregulation of our markets allows them to more effectively reflect true supply and demand.
    Stagflation was an issue in the United States during the 1970s, particularly during the Carter administration. Stagflation is certainly a conundrum for investors. The best investments during inflation are not the securities to own during stagnation/recession. My hope is the government recognizes we do not want to be where we were during the Carter administration and resolves the uncertainty.
     Inflation means it is NOT time to own fixed income products. Fixed income securities include certificates of deposit, bonds and fixed annuities. A fixed income investment is anything where the rate of return is “fixed” or locked in for a certain length of time. As prices rise, the fixed income investor cannot raise his/her return to meet the demand of a higher cost of living because the return is “fixed.” They may be forced to dip into principle to make ends meet, and this decreases net worth, which also decreases future earnings. Spending principle means your portfolio takes a hit, the same hit that a growth portfolio takes with a market correction. However, money spent is never recovered. With a well-diversified growth portfolio, market losses are generally recovered over the long term assuming the stocks owned are solid, reliable companies.
    There is a second reason to NOT own fixed income products during stagflation. When interest rates rise, the value of fixed income products such as bonds and annuities fall; they lose market value. Investors are not interested in purchasing your bond at four percent if they can purchase a new bond with a higher rate of return because interest rates have increased. If no one wants your fixed income product at the lower rate of return, the market value of that product decreases; you must sell it at less than maturity value to get anyone to buy it.
    During inflationary times, such investments as growth stocks continue to thrive, particularly in such sectors as energy, metals and mining. These firms enjoy high profit margins under inflationary cycles resulting in an earnings increase that is passed on to shareholders. Debt is locked in at a fixed rate of return, but a higher cost of living allows prices to rise. Fixed debt with rising prices equals more profit. Real estate investment trusts do well, again because debt is locked in while prices continue to rise.
    The opposite is true during economic cycles of stagnation, or recession. Stagnation means interest rates will fall. This is the time to own fixed income products such as bonds. As interest rates decline, your particular bond becomes more valuable because the rate was locked in at a higher return. Now other investors are willing to pay a premium for your higher return since anything they purchase today returns less interest. Utility stocks and preferred stocks also hold their value. Again, as interest rates decline, these firms can refinance debt at the lower rates to increase profits for shareholders. Pharmaceutical companies and food companies are good investments. Regardless of declining purchasing power, people continue to purchase both food and medications as necessities.
    During stagnation those investments that we consider true growth companies are hit hardest. Tech stocks, energy and metals suffer. Stagnation or recession is NOT the time to be a growth stock investor. Less purchasing power means consumers purchase fewer goods and services and make an attempt to conserve energy. Purchases in sectors such as tech and metals (autos, for example) suffer, and profits fall.
    During hard economic times such as stagflation, I feel all investors require a qualified financial advisor to help maintain their portfolio profitability and protect net worth. During times of economic growth, it is a question of profit and return. During times of economic downturns, and particularly during stagflation, it is a question of protecting net worth. Next month my article will tell you how to evaluate a financial advisor and choose a knowledgeable advisor who is right for you.
    Fred Dowd has more than 30 years experience as a portfolio manager. He founded The Fred Dowd Company, a very successful and well-respected money management firm with clients nationwide. His firm has become Yellowstone Partners. While no longer licensed in his field, Fred still participates in Yellowstone Partners as Chief Investment Officer and research analyst. He continues to help ranchers and businessmen nationwide with their investment portfolios. Fred is now at home on his ranch near Buffalo. He may be reached via telephone at 307-684-2169 or via email at fredldowd@hotmail.com.