Stagflation Is Now On The Table

by: Paul Nathan


Stagflation is becoming a real possibility for the first time in 40 years.

As food, shelter, and gas prices soar, GDP fell last quarter to .01%.

A profit squeeze and a fall in company earnings may be the catalyst for a fall in stocks.

The one word we haven't heard tossed around for a very long time is "stagflation." Yet the message of the markets is beginning to signal just that. We're seeing slow growth from China, Japan, Europe, and the US, and most of the emerging economies around the world; and this at a time when many commodities are rising.

We haven't seen stagflation in this country for over 40 years. It's a phenomenon where the economy virtually slows to a crawl but is plagued by persistent and progressively higher prices. In the 1970s we saw the US growth rate at around plus or minus 2% for ten years. During that time we saw inflation progressively rise from 2% to 12%. Interest rates rose to 21%, unemployment to over 10%. The dollar plunged, gold soared, and the stock market fell and stayed flat on its back for a decade.

I'm not saying that stagflation has set in, but there are signs that it could be rearing its ugly head. The signs are in the contradictory data coming out weekly. For example, we saw recently where food, shelter, and gas prices rose, while retail sales, industrial production, and home sales fell. The one thing that could be spooking the market is that some companies are experiencing higher costs, and not able to pass them on in a sluggish economy. Many companies are suddenly experiencing a profit squeeze.

And then there's the bond/stock market dichotomy. Interest rates normally fall due to falling growth and falling loan demand. And as we've seen, interest rates have inexplicably been falling as the stock markets rose to new highs not just in the US, but around the world. Is the stock market right in foreseeing higher future growth and higher earnings, or is the bond market correctly predicting lower growth than expected?

I've been of the view that the economy would experience a really bad first quarter, but would snap back in the second half of the year. I forecasted a turn in gold in December of last year as I reasoned that commodities in general would rise along with world growth and rising inflation, and that the US would finally breaks out of its 5-year stagnant disinflationary pattern. I'm still looking for about 2.6% growth for the year as a whole and a 2-4% inflation rate over the next couple of years.

This is no longer theory but fact as inflation on the wholesale level has risen to over 5.5% for the last 2 consecutive months as the CPI is moving closer to the 2% range. When Americans were asked in a recent poll, "what is your greatest economic worry?" the number one answer was, "inflation". And when asked about the economy, most Americans believe we are still in a recession. According to polls, we have stagflation now as far as most Americans are concerned.

If Americans are right and most economists are wrong and it is stagflation, not inflationary growth ahead, then watch out for a resolution to the present stock market/bond market dichotomy. It could lead to a sharp fall in the stock market that's counting on future increased growth and earnings. That certainly has been the message of the markets over the last couple of trading days as stocks fell along with interest rates - both anti-growth signals.

The "fly in the ointment" to the stagflation theory is the falling interest rates that should be rising if inflationary expectations are increasing. But low interest rates could be masking growing inflation.

Back in February of 2005, I wrote an article called "The Greenspan Conundrum". It had to do with why interest rates were falling inexplicably. Then as now, there were concerns about deflation and recession, yet real estate prices were rising briskly. Gold was strong along with the stock market, but the bond market was telling a different story.

Most economists and commentators along with Alan Greenspan who raised the conundrum question of falling interest rates, were scratching their head over this contradiction, just as everyone is today. There were those saying that the falling interest rates were predicting an imminent deflation; others were warning of a recession. But the economy continued to grow with low inflation through the rest of 2005, 2006, and 2007 with no downturn in the economy and a stable overall inflation rate.

My take on the Greenspan's Conundrum was that it could have been the result of demographics. It was the beginning of 77 million baby boomers retiring. I suggested that as the aging of America proceeded, it was reasonable to expect the investment decisions of those retiring to shift from risky investments to safe investments.

Today, trillions of dollars have not returned to the stock market. Over the years it went into bonds, gold, and second homes instead. Most previous money in the stock market still remains on the sidelines in money market funds and saving accounts. The return on these funds is zilch, but those that make the decision to leave their money in what amounts to cash, are evidently more interested in the return OF their savings rather the return ON their savings.

As everyone looks for an explanation of why interest rates are so low, many are predicting a deflationary recession, a stock market collapse, and/or a return to a world-wide economic slowdown accompanied by new financial panics. But let's not forget the other possibility: that America and the world at large is growing older, retiring, and are choosing to keep their money in government bonds, and other "safe" investments, and more in cash than ever before.

Perhaps the reasons that interest rate are falling through-out the world is that investors are not interested in "investing" any longer. Perhaps a large segment of the world simply wants to keep what they have. We are all looking at the bond market through the eyes of economists and investors, and we're all concluding that the low rates make no sense what's so ever. Maybe, just maybe, the downward move in interest rates doesn't reflect anything of importance to the economy. Maybe it's simply a genuine market expression of people who are getting older wanting to take less risk.

If so, low interest rates may not move higher as inflation goes higher as they normally have. They may continue to respond instead to a slowing and unpredictable economy. If that's the case we won't get the normal alert signal of rising rates to rising inflation expectations this time around. Instead we may see inflation move to 2-4% over the next couple of years with long rates moving up only marginally. If so, gold and most other commodities will be our first "tell" to rising inflation. And a falling stock market will reflect slow growth and a profit squeeze on future earnings.

Stagflation. Keep an eye on it.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GLD, TZA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.