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February 26, 2015

Get Your Portfolio Ready For The Coming Stagflation

By Joseph Hogue, Street Authority
The global economy can deliver a jolt to stock markets at any moment. These "Black Swan" events are hard to predict or anticipate, but are always on the back of our minds.
Sometimes, we can even develop a vague sense that something is brewing. For example, investors could sense that market trouble was coming in 2000 and 2008, but the likelihood of trouble was so far outside of market sentiment that few were prepared.
With central banks and investors around the world completely preoccupied with deflation, could rising price pressures be the next unexpected event for which you should be preparing?
The clues are all there and we may be in for a trend of low growth, high unemployment and increasing prices. That combination, last seen several decades ago, is referred to as "stagflation."
Disco Fever And The Great Stagflation
The last time stagflation reared its ugly head, bell bottoms were all the rage and Richard Nixon was just starting his second term in the White House. Economic growth -- adjusted for inflation -- was an anemic 3% for the rest of that decade. Indeed ample price pressures meant that the S&P 500 fell more than 30% through 1980 (adjusted for inflation).
Stocks typically provide a good hedge against moderate inflation, as companies can increase their prices to offset higher costs. As long as price changes do not increase quickly, management can forecast cost increases and build it into product pricing.
Faster inflation growth adds an element of uncertainty and corporate profits fall behind. Add in higher unemployment and weak economic growth to create stagflation and companies might not even be able to increase product prices at the rate of inflation.
Right now, that would seem to be of little concern. Outside of Latin America, core inflation has been quite subdued -- less than 1% across the developed world in 2014.
Is there really any possibility to stagflation if pricing pressures are virtually non-existent? Yes, that possibility surely exists.
Although economists have a pretty clear sense of projected 2015 GDP growth rates, they aren't in a position to project inflation rates: Research of inflation expectations by the Federal Reserve over the last 40 years showed that expectations were typically off by 15%-to-20%.
Inflation In 2014GDP Growth In 20142015 Expected GDP Growth
United States0.80%2.40%3.60%
Latin America8.70%1.30%2.20%
Source: U.S. Bureau of Economic Analysis, Center for Latin American Studies (Univ of Florida), International Monetary Fund, The Economist
Meanwhile, central banks have stepped up their policy of competitive devaluation. The Bank of Japan is only halfway through its historic monetary stimulus and the European Central Bank has just committed to increasing the amount of euros in the system by more than $1.2 trillion through 2016. With so much money being pumped into the system, we may be closer to faster inflation growth than you may think.
Even as these central banks try to induce inflation (in a bid to avoid outright deflation), unemployment levels remain persistently high in many parts of the world.
In worst case scenario, these central bankers induce price pressures (which would eat into corporate profits and stock prices) even as they fail to bring down unemployment levels. That should lead investors to think about how various kinds of investments would fare in such an environment.
Positioning For Low Growth And High Inflation
Consumer staple and healthcare stocks tend to do relatively well during stagflation. That's because consumers can't easily cut spending on staples such as milk and medicines. Larger companies can negotiate with suppliers for more favorable pricing and strong brands may be able to pass some prices on to consumers.
These stocks generally pay a higher dividend yield, which also helps to offset inflation through immediate cash return. The Consumer Staples Select Sector SPDR ETF (NYSE:XLP) holds shares of 40 companies with a median market cap of $22.2 billion and pays a 2.4% dividend yield.
Utilities are also relatively protected from a stagflation environment since essential services such as water, heat and gas are less likely to be cut from consumers' budgets. The regulated price environment also allows for companies to pass on some of the higher costs. The Utilities Select Sector SPDR (NYSE: XLU) holds shares of 30 companies with a median market cap of $16.1 billion and pays a 3.3% yield.
The gold bugs have been spurned for nearly four years, but could soon be proved right. Gold would perform well as a hard-asset, and also as a safe-haven investment on the debasement of global currencies and higher prices. Lower and more uncertain economic growth could drive more geopolitical risk, which would drive investors to safer stores of value. SPDR Gold Shares (NYSE: GLD) are down 10% over the last year, but seem to have found a bottom with gold prices around $1,200 per ounce.
One key area to avoid: Consumer discretionary stocks would take a stagflation-led hit as consumers cut back and retailers are not able to pass on price increases to customers. TheSPDR S&P Retail ETF (NYSE: XRT) holds shares of 101 U.S. retailers and is valued at 23 times trailing earnings, higher than both the consumer staples and utilities funds. Retailers have blamed tepid international currencies for recent weakness, but sub-3% economic growth has not helped consumer spending either. Consumer spending in the United States fell 0.3% in December, the biggest monthly decline since 2009.
Risks To Consider: Pricing pressures have failed to materialize six years after the global economic crisis, and deflationary risk is still the buzzword for some economists. Investors may want to gradually position their portfolio for higher prices over the next year or two while avoiding stocks tied to consumer spending.
Action To Take --> Pay attention to the macroeconomic writing-on-the-wall, and start positioning your portfolio for the possibility of a stagflation-type global economy over the next several years.
Courtesy Joseph Hogue at Street Authority (EconMatters archive here
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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