Thursday, April 7, 2016

Odds Rising for a Return of Stagflation

Stagflation is an financial market phenomenon in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high.

Since President Obama was elected in 2008, the U.S. financial market has traded with a haunting fear of a return to much higher levels of inflation combined with low economic growth.  The low growth part of the prediction has been born out throughout Obama’s now seven plus years in office.  However, inflation fears have turned out to be overdone.  When President Obama took office, the CPI index stood at 211.4.  As of year-end 2015 the index stood at 237.85.  (See CPI Data)  Inflation thus far in the Obama years has been on 1.68% annually.

Meanwhile nominal economic growth as measured by the Gross Domestic Product was $14.6T at the end of 2008, and measured $18.2T at the end of 2015, a growth rate of 3.19%.  (See GDP Data)  Nominal GDP is calculated including inflation, so real economic growth during the time period has been growing at an anemic pace of approximately 1.51%.

If you look at the recent trends in the economic statistics, the growth versus inflation performance is actually better.  In 2015 the CPI increased by only 0.72%, while GNP expanded by 3.12%.  Again, the numbers have trended toward very low inflation, and low to moderate growth.

A recent MarketWatch article on 3/24/2016, Stagflation could be latest 1970 trend to make a comeback, raised the specter that risk is increasing that U.S. economic growth is headed for a slowdown, meanwhile inflation is likely to head higher in the next year and beyond, just as Obama exits office.  For stagflation to recur, according to Bank of America’s standards, GDP growth would need to slip below 1.4% while the quarterly growth rate for core inflation (ex-energy and food price changes) rises above 2.3%.

Looking at general economic trends, the forecast for stagflation this time around, versus the false alarms throughout the Obama tenure in office, now has greater likelihood of being borne out in future economic results.  Why?  Here are 3 market signals which investors should follow which are trending toward higher inflation in the future, and lower economic growth:

Oil Prices:  At $38 per barrel, the price o f oil is down 17.80% over the past year, and down substantially since June of 2014 when it traded at over $100 per barrel.  However, the trend in prices is definitively upward since February of 2016, and forecasts are for oil prices to return to $50-$60 per barrel in 2017.  With the major cutbacks in drilling investment throughout the world, it should surprise no one if the current forecasts underestimate the price rebound strength of oil once the current over-supply in the U.S begins to dwindle by year end 2016.  Just as in the 1970s, a spike in oil prices was the precursor to a very serious bout of stagflation.

Corporate Cut-backs:  The U.S. economy is currently past peak in the employment growth cycle.  In the latest monthly total non-farm employment data, new job creation was 215,000.  This data was accompanied by a tick upward in the unemployment rate from 4.9% to 5.0%.  Many economist view the current U.S. government employment data as severely over-estimating the health of the current U.S. economy due to the magnitude high number of workers excluded from the survey because they have stopped looking for work.  More concerning data, however, is visible in the increasing number of company lay-offs in 2016.  For instance, in its recent report, Challenger reports 63% rise in layoff announcements on oil-price collapse.  The strong U.S. dollar is also wrecking havoc in many U.S. tech firm operations like Hewlett, Intel, Microsoft and Unisys.  (Tech Sector Shed Over 79K in 2015, 13 Percent of All Cuts).

Federal Reserve Easy Money:  In December of 2015 the U.S. Fed increased short-term interest rates for the first time since 2006.  Many critics of the Fed have voiced opinions that the Fed left rates too low for too long, and continues to be too slow.  However, the Fed is mandated by Congress to respond with easy monetary policy as long as inflation is low and unemployment is considered too high.  The statistics show that this has been the case in the U.S. economy since Obama took office.

The real issue is whether the Fed extreme policy of leaving rates at 0% for so long has set the stage for the stagflation to now return.  In the 1960’s and 70’s, the Fed monetary policy was very similar in approach to the current policy – they lowered interest rates substantially to encourage unemployment to fall.  The technique is based on an economic theory known as the Phillips Curve.  The results in the early 1970s were disastrous, as President Nixon found out, and his predecessors in office until 1980 when Paul Volker assumed the Fed chairmanship took the painful steps to extract the country from the misguided monetary policy measures.

Policies in place for Stagflation to make a return

Will the upcoming bout of stagflation, if it occurs, rival the intense high interest rate, high inflation rate scenario encountered in the 1970s.  My research which is published in the book, Theory of Financial Relativity, predicts that the outcome will depend largely on the U.S. government policy going forward, in particular the U.S. Treasury demands for low rates to finance the U.S. deficit relative to the rate of growth in federal budget expenditures.

In November of 2015, Republican Paul Ryan took over as House Speaker, and ironically his first action was to lead the approval of a 2016 budget that dramatically increased federal spending levels when compared to the previous 5 years.  When this action is combined with a Federal Reserve that is hesitant to take action to return interest rates to a historical normal level, the odds are now much higher for stagflation to return as it did in the 1970s.  All this said, the U.S. economy has a long way to go before the situation can return to the extreme situation faced in the 1970s.  These issues take time to materialize.

In this financial environment, I favor commodity based investments and gold, which have been severely beaten down over the last several years.  Note the correlation in the decline in these sectors to the very low growth rate in the U.S. fiscal expenditures.  Now that these sectors have all been severely reduced in value, and U.S> policies in the process of changing, these investments will be much better stores of value than U.S. stocks (SPY) (DIA) (QQQ), or U.S. Treasuries (TLT).

Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor.  All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.  He holds no positions is securities referenced in this article.

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