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In spite of a blockbuster reporting season, equity markets haven’t been performing terribly well lately. Major averages lost more than 4 percent last week—the worst for the year.

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Investors have been blaming Washington’s failure to reach a deal on the nation’s soaring debt for the market decline, expecting a sharp rebound once a deal is reached.

Deal or no deal, we do believe that equity market woes can be traced beyond Washington, to the rapid weakening of the world economy, as evidenced by a string of disappointing US data, including weak May and June employment reports, and Friday’s weak GDP report confirm that the US economy is heading for a prolonged stagnation-at a time that both monetary and fiscal policy are max-out.

The weakening of the world economy is confirmed by disappointing earnings guidance by US companies with a large international presence like Emerson Electric (NYSE:EMR) United Parcel Services (NYSE:UPS), Caterpillar (NYSE:CAT), and Novellus Systems (NASDAQ:NVLS). But what it means for investors?

Focus on the direction of the economy rather than on the direction of politics. Sooner or later, Washington will reach a deal, but it won’t be sufficient to avert a prolonged economic stagnation, as both monetary and fiscal policies are max-out.

While a slow-growth-low-interest rate environment is usually good for stocks, a prolonged stagnation isn’t, as evidenced by the performance of the Japanese equity markets—the Japanese economy has been in stagnation for almost twenty years! This means that investors should stay away from cyclical stocks that are highly sensitive to economic conditions, and be selective even with non-cyclical stocks. Accumulate positions in pharmaceuticals like Pfizer (PFE), Bristol-Myers Squibb (BMY), Eli Lilly (LLY), Merck (MRK), and Novartis (NVS) that pay good dividends; and stocks with steady earnings like Starbucks (SBUX), and lately, McDonald’s (MCD).

Disclosure: I am long PFE, BMY, LLY, QQQ.

Source: Economic Stagnation: Not Good for Equities