Stagflation: History Repeating Itself?

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 |  Includes: DIA, QQQ, SPY
by: David Powell

Earlier this week, the New York Times ran an article entitled: That 70s Look: Stagflation. The gist of it? The US is experiencing slower economic growth that requires a rate cut by the Fed. This is coupled with rising commodity prices. Sounds like, seems like stagflation. Similar stories have appeared in the Telegraph [UK], Guardian [UK] and Wall Street Journal. For those who remember, the 70s were a difficult economic period. As you can see below, in a chart of the Dow during the '73-'75 recession (indicated by the gray area), the index declined 28%. So what do I think will happen this time?

click to enlarge images

First, I think we are already in a recession. And I think housing will take years to unwind. My guess (and it's exactly that, a guess) is that the market will be level for a while and then drift lower slowly. I feel (this is a gut/intuitive impression) that there is no hurry to buy now if you are a long term investor, which I am. While I am a bull by nature, I sound like a bear these days, but a lack of realism never made anyone any money. And at the current interest rate levels, the Fed only has so many arrows left. I think its time to amass capital and wait for buying opportunities.

But how similar is today, really, to what happened in the 70s? The chart above is the annual rate of inflation during the 70s decade. A large part of the inflation then was caused by an increase in the price of oil. In 1973, OPEC met in Tehran and doubled the price of oil from $5.50 to $11.00 per barrel. Part of the reason for this price hike was the Shah's desire for more foreign exchange in his bid to buy more military equipment. The other factor driving the rate hike was the fall of the dollar (compared to the pound below, 1973-2007):

Since the real interest rate = the nominal interest rate - inflation, real interest rates were negative for part of the early 70s when GDP growth was low, causing inflation. For 2007, recent estimates are that inflation was 3.5% for the year, while economic growth slowed to 1.5%, see BBC story. Growth will be slowed, of course, by the housing and credit turmoil underway. High oil prices are also a factor today, just as they were in the 70s. If the Fed cuts rates further, it will be at or possibly below the current rate of inflation, creating negative real rates. If the housing and credit problems become an increasing drag on the economy, the high inflation-slow growth combination may be realized.

On the other side of the Atlantic, Europe has also rising consumer prices and falling output. The European Central Bank [ECB] now has to formulate monetary policy to deal with inflation and boost growth. In the UK paper Telegraph, Veronique Riches-Flores, Europe economist at Société Générale, said "investors were deluding themselves if they believed that Europe and the rest of the world could carry on growing briskly as the housing slump engulfed America."

This may, however, develop into a good time to buy industrials, banks and other unloved sectors if you are a long term investor. The one potential upside to a market slowdown is that some quality stocks get dragged down with the rest. You just have to be patient; it's a virtue, so they say.