Stagflation: The Return of an Insidious Scourge

Includes: ABT, JNJ, NVS, TEF
by: Bret Jensen

It was a good day yesterday for the free world with the demise of Osama Bin Laden. The head of Al Qaeda was an insidious scourge on the earth. Unfortunately, we are starting to face another insidious scourge; one the world has not seen in decades and has the capacity to pull millions more in the developing world into poverty and have negative consequences for the markets and economic well being the world over. It is called stagflation.

It is becoming increasingly clear that we are facing more and more signs that worldwide growth is slowing at the same time inflation is accelerating. This is not a good confluence of trends, and could usher in the stagflation we have not seen since the Carter years. If these trends do not reverse in short order, the markets could be in for some rough sledding. The last time stagflation took hold was in the late 70's, the P/E of the market got down into the single digits. Here are the worrying signs in the top four economic blocks:

United States – 1st quarter GDP growth came in at 1.8% which was much slower than the previous quarter's 3.2% rate of growth. The GDP deflator also rose to 3.8%, the highest since Q32008. The accelerating pace of inflation in food and energy over the last year is very concerning. Gas prices are up 30% this year and are approaching $4/gallon nationwide, and have already reached that level in six states. Food prices are up across the board with good gains in the grain complex as well as dairy and meat. CPI, ex food and energy, does not look worrying but mainly because the moribund housing market makes up so much of the Index.

China – The newly minted second largest economy in the world is having problems with inflation which is causing increasing social unrest including trucker's strikes. The March consumer price index show prices up 5.2% for the year, up from 4.9% in January and February. The government has taken several measures to cool growth and property speculation including several interest rate hikes. China also has started letting its currency slowly appreciate and recently penciled in 7% growth for its new five year plan, down from 7.5% in its last five year plan. The Chinese government is getting more focused on price stability and increasing consumption. This will eventually provide more balance to their economy, but is also likely to slow growth in the short and medium term.

Japan – I don't even know where to begin with the third largest economy in the world. Between the earthquake, Tsunami and nuclear disaster Japan has been hit with the perfect storm. S&P just lowered its outlook on Japan as it sees an additional 3.7% of GDP going to deficit spending through 2013 as a result of the disasters. Given that Japan already has a debt to GDP ratio of over 200%, its financial flexibility is challenged at best. March factory production fell 15.3% from February, more than expected and the biggest decrease on record. The Land of the Rising Sun will be lucky to achieve a 1.5% GDP growth rate for 2011, down substantially from the 3.9% growth rate of 2010. Although slowing economic growth should reduce inflation in most areas, supply chain disruptions and having a substantial amount of energy producing capacity knocked out; should lead to increasing inflation in other areas.

European Union – German inflation just hit a yearly high. This could force the ECB to have further increases in interest rates despite the dire state of the periphery economies such as Spain whose employment just crossed over 21%. The finance minister for Ireland just reduced his country's growth forecast from 1.7% to .9% and IMF projects it will be closer to .5%. Given the austerity measures enacted throughout the region, it is hard to see how growth will be robust anytime in the near future. In addition, Europe is much more dependent on oil from the Middle East and could be inadvertently impacted by the accelerated turmoil in that region.

Given slowing growth and rising inflation it is hard to see the markets going up much further from here. Company revenues should be adjusted lower and profit margins are likely to be impacted by higher costs. I think there will be better opportunities to pick up good stocks at lower prices in the near future. I am keeping a good portion of my portfolio in cash and defensive sectors like pharma and utilities that have reasonable valuations and good dividend yields. Abbott Labs (NYSE:ABT), Johnson & Johnson (NYSE:JNJ), Novartis (NYSE:NVS), and Telefonica (NYSE:TEF) are good picks here and ones I have chronicled in other articles. Be careful out there.

Disclosure: I am long ABT, NVS, JNJ, TEF.