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Is Stagflation the Next Blow for Investors?
You’d think that the economic shocks from disasters are relatively old hat. For example, when a hurricane hits Florida the following typically occurs: businesses shut down; people are unemployed; prices of scarce goods jump.
After a while, a recovery gets underway and employment rebounds and things slowly get back to normal. But the impact tends to be regional in nature NOT nationwide.
COVID-19—what we are experiencing with COVID-19 is something the modern world has never seen (government shutting down businesses all over the country for more than a month). No one is exactly sure how this pandemic will play itself out, but one potential consequence could be stagflation.
Stagflation—the term “stagflation” is a combination of economic stagnation and inflation. It is a perfect storm of bad economic news: stagnant (slow or declining) economic growth; declining gross national product; high unemployment; rising prices, i.e. inflation.
Stagflation can result in a potentially long period of economic malaise that can impact long-term investment returns and return expectations. The most common cause of stagflation is government policies that disrupt normal market functions.
Prior to March 2020, the U.S. economy was strong with relatively low inflation. In April 2020, the economy shut down except for essential businesses in most states, the stock market fell more than 35%, unemployment is out of control, and there is no certain end in sight.
Where do we go from here? We have a massive government stimulus program, but consumer spending is way down and business shutdowns are expected to persist into May and beyond. Any hopes for a V-shaped recovery from the shutdown in economic activity appear very dim.
Getting to know stagflation—according to Keynesian theory, a stagnant economy and high inflation should be impossible. In a normal economy, slow growth prevents inflation. Low consumer demand keeps prices from rising.
The 1970s proved the theory a fallacy. From 1973 to 1975 the U.S. economy reported five quarters of negative GDP. The U.S. stock market lost 50% in 20 months and investors took nearly a decade to recover their losses.
Stagflation started in the 1970s with OPEC cutting oil exports to the U.S. in retaliation for the U.S. decision to resupply the Israeli military. Oil prices quadrupled driving up the costs of consumer goods so fast that wages failed to keep up and a mild recession began.
In response, President Nixon instituted a 90-day freeze on all wages and prices to control inflation and imposed a 10% tariff on imports to protect domestic industries. U.S. companies couldn’t raise prices to remain profitable and couldn’t lower salaries, so they laid off employees to reduce costs.
The Federal Reserve raised interest rates to fight inflation, lowered them when businesses stopped hiring to fight low employment, then raised them again.
Stagflation lingered until falling oil prices combined with President Reagan’s focus on supply-side economics helped the U.S. economy start a recovery in 1983.
Historically, stocks that offered the greatest potential for profit during stagflation were health care, food, and utilities. During the 1970s, commodities including gold, oil, and industrial metals performed well. It was also a good time to invest in world currencies as the U.S. dollar was declining in value. Given the current flight to the U.S. dollar, the opposite is happening today.
What’s next in 2020? At this point, 3-scenarios could play out (we just don’t know which one).
1) The massive government stimulus and surge of liquidity could be inflationary; or
2) Damage to the economy could cause a global recession with deflation; or
3) Stagflation could make its return.
Tactical Money Management—counting on the market to rise as a whole from international demand or emerging economies may be a false hope if COVID-19 has a long-term effect on the world economy. For investors looking for long-term gains during a Stagflation time frame, it’s essential to work with money managers who can find the right asset classes at the right times. My preference is to use tactically managed strategies that hedge risk to the downside and look for specific opportunities for gains.
Which would clients like better? The black line is the SPY and the green line is an aggressive tactical strategy. To sign up for information on several high quality tactical strategies, click on the following link: