Stocks hit five year highs last week on the back of a fiscal cliff deal that successfully kicked the can down the road for a few months. Not to look a gift horse in the month, but I believe policy makers and the lack of the political leadership has put in place a foundation that will invite stagflation in the years ahead. Prudent investors should start to plan now for the increasing inflation and continued slow economic/job growth coming down the pipeline. In this article, I will refute two of most common arguments made against the prospect of stagflation. I will then chronicle how we got into this position by the decisions of shortsighted central bankers and poor policy decisions by political leadership. Finally, I will offer some suggestions on how one can position their portfolio to take advantage and prosper by the return of stagflation.
The two common arguments I get against my thesis of the coming onset of stagflation are that the stock market is doing just fine despite the financial crisis of the past five years and the other is that if inflation is due to escalate why are government debt yields so low? Let's tackle both individually. First, I believe the liquidity engineered by the Federal Reserve has already led to asset inflation and will eventually find other aspects of the economy. Yes, stocks are back to where they were five years ago and the stock market has had a great run over the past couple of years. However, that is only if one prices the market in a paper currency like dollars. If you look at the market trajectory priced in more traditional (and less manipulated) stores of value like silver & gold, the market is selling at half what it was in 2007 (See chart).
Second, one of the primary reasons government bond yields are so low is that the Federal Reserve is buying the vast majority of new Treasury debt. One should find it ironic as well as insightful that the current Fed program of buying $85B a month in government debt and mortgage securities adds up almost perfectly to the $1T deficits Washington is running up annually. Consider that on a total national debt of approximately $16T in 2012, the United States got away with paying under $400B in interest. Imagine a highly probable scenario where our debt rises to $20B by 2016 and the interest rate we need to pay on that debt rises to a more traditional 4% to 5%. The annual amount of interest the United States will need to pay on its growing deficit will increase by $400B to $600B on an annual basis. Think of the ramifications for the budget, taxes and the future course of the country.
The two components of stagflation are increasing inflation that is almost always the result of poor monetary policy and a fiscal policy that results in slow or no economic and job growth. Let's look at monetary policy first. Ben Bernanke has provided an unprecedented amount of monetary support since the onset of the financial crisis in 2008. His first Quantitative Easing efforts were much welcomed and needed by the market and the economy. However, each successive program has been less effective and it has reached the point where they are preventing the market and the economy to returning to a normal equilibrium. I believe the Fed chairman's heart is in the right place, but his lack of non-academic background makes him naive on two fronts.
First, the chairman misread how his efforts would play out with the banks and with companies. His intentions were his efforts to provide a huge amount of liquidity would find its way through these two channels to bolster the real economy. The banks have tended to hold on to this largesse for some simple reasons. Loan demand from qualified sources remains low and they have tended to use these cheap funds to bolster their own balance sheets and/or just reinvest the money back into ultra-safe Treasuries. They also are getting hit by various and competing aims of government. The Fed wants them to lend more money at the same time state and federal regulators want them to continue to tighten their underwriting standards. Companies have used this liquidity for uses not envision by the Federal Reserve. They have refinanced higher yielding debt and used it to buy back stock and increase dividends. This is not the ramp up in business investment and hiring the Fed desired. However, given the uncertainty in the economic and political environment as well as an administration that hardly can be called business friendly, it is hard to fault these decisions.
The second key area that the Federal Reserve chairman has been extremely naïve about is the nature of current Washington politics. I think his sincere view was and continues to be that if he bought time for the politicians that eventually they would behave like adults and come up with a "Grand Bargain" along the lines of Bowles-Simpson that would address the long term deficit problems of the country without blowing up the economy in the meantime. I think that the minutes from the FOMC show that a good portion of the committee is finally getting disabused from this naiveté even if the chairman continues to hold to his illusions.
Ben Bernanke is not the only central banker that finds himself caving in to political pressure. The central bank of Japan has pretty much signaled that it will knuckle under to the recently elected Abe to devalue the currency; which has led to significant losses for the yen in the last few weeks. The ECB has already extended itself past its original charter in supporting Italian and Spanish sovereign debt ensuring their governments can continue to finance their exploding debts at reasonable rates, at least in the short term. I would look for the ECB to expand their largesse once the re-election of Merkel is ensured and those pesky Germans and their sound money views can be bypassed.
On the political/fiscal policy front lay the other driver towards our future of stagflation. None of the major players has acquitted itself well. The Republicans have not been able to control the narrative so that necessary spending and entitlement cuts come to the forefront (Tax revenue is down only 3% since 2007, government spending is up some 35% over the same timeframe). The president and the democrats have managed to do a successful job of keeping the conversation around the need for the top 2% to pay their '"fair share", but the $60B annually they got in the recently passed fiscal cliff deal does little to reduce debt in lieu of trillion dollar annual deficits.
One thing I think that has not been highlighted enough is why the unemployment rate has fallen over the past few years. Almost the entire decrease is explained by decline in labor force participation over the last four years (See chart). Some of this is explained by the baby boomers retiring, but the majority of the decrease consists of people dropping out of the workforce and either going on disability, on the government dole or for a small subset; back to school mainly on government loans. None of this does much for the long term well-being of these workforce dropouts, our budget or the overall economic growth rate of the country in the future. Something similar occurred in England from 1997 to 2009 when the disability roles went from 600,000 to 2.6mm individuals over those dozen years.
In summary, we have a huge and growing deficit with no will to tackle the real causes of the huge increase of our national debt. The Federal Reserve has already tripled its balance sheet and is on a path to quadruple it by yearend. Finally, our recent fiscal policies have made it more expensive to run a business and hire (Obamacare, higher taxes on successful S corporations, increasing regulation, less certainty, etc. …) while decreasing the incentive to work (Continued extension of unemployment benefits, much higher welfare and food stamp populations and the recent expiration of the payroll tax holiday). Not exactly a recipe for robust job growth.
So where does that leave us? It seems we will not address the core causes of our deficit and we cannot expand the Federal Reserve's balance sheet forever. We certainly cannot grow our way out of our problems with the 4% to 6% annual GDP growth that would be normal coming off a deep contraction with current fiscal policies. That leaves the one avenue all major debtor nations eventually take, try to debase your currency and inflate your way out of your debt. This always results in much higher inflation. Combined with continued low economic/job growth gives you stagflation which has not been in the general lexicon since Jimmy Carter's presidency.
The good news is that an investor can still make money in this environment if positioned correctly. First, bonds are going to a horrible place to be, especially government bonds. The thirty year bull market in these bonds is coming to an end. One can just avoid these instruments or benefit from rising interest rates by using an ETF like (TBT) that rises along with government debt yield. It has had a solid run in the last month as investors anticipate higher rates in 2013 (See chart).
Consumer Discretionary stocks like retail should also be avoided. They have been some of the best performers in the market since the nadir of March 2009. However, they will face higher input costs as inflation increases as well as stagnant wages of their consumers. Restaurants should also have the additional burden of higher costs because of Obamacare and I would avoid that sector altogether.
Hard assets and business models that through off good and rising dividend payments will be good places to allocate money. I particularly like some of the energy infrastructure MLPs for their high yield and their participation in our continued domestic energy production ramp up. Ones I think will do well and hold include Linn Energy (LINE), Calumet Specialty Product Partners (CLMT), Access Midstream Partners (ACMP) and Martin Midstream Partners (MMLP). Commodity stocks should also do well in this environment. Freeport-McMoRan Copper & Gold (FCX) is one of my favorites in this sector and is cheap and has a good dividend (3.5%) as well.
Be careful out there