Stagflation Stinks...

Although I have been predicting an impending period of stagflation since September 2007, I was secretly hoping my thesis would not materialize. Unfortunately, data continues to pour in from different sectors of the economy that point towards an inflationary induced profit squeeze and the dreaded no-growth high-inflation combo (the ‘un-happy meal’). The newly released data from the Institute for Supply Management (ISM) showed a developing trend towards a contraction in the non-manufacturing sector brought about by higher input prices. In fact, respondents of the ISM survey in the Transportation and Warehousing sector say that “Oil prices are affecting most every supplier we have” http://www.ism.ws/ISMReport/NonMfgROB.cfm. As input prices of production rise and businesses are unable to pass on those costs to the consumer, profits across the economy will be squeezed. It is my view that corporate profit expectations for the 3rd and 4th quarters are too high, and although those companies with an international presence could continue to benefit from a weak US dollar, growth across the broader economy will remain sluggish. A systematic lowering of profit expectations across the economy will be a negative for the stock market as traders discount prices for stagnant growth and a fragile profit environment.

Expectations are what drive markets, and the key to a successful turnaround in this economy will therefore come from a fundamental shift in this crucial area. It is inflationary expectations that are causing a decrease in production and a cut in jobs. Profit expectations are tied to input costs and capacity utilization, which is closely linked to inflation. Investment spending in the US is linked to the expectation of currency appreciation and tax policies; both of which look grim under the current easy money Fed and the strong possibility of the country having a Democratic President and Congress. All of the aforementioned expectations can be successfully controlled by a coordinated policy effort aimed at a strong dollar and low corporate tax rates to induce a sustained level of investment spending. I don’t think the fed has to worry too much about the classical negative effect that slightly tighter monetary policy has on growth as the linkages in private sector borrowing have already deteriorated from the fed funds rate. Also, if the Fed continues to hold open access for nonbank institutions to the discount window, sufficient liquidity will remain in the system to prevent the possibility of a crisis of confidence in the financial sector. Inflation will likely be the buzz word for the remainder of 2008 as the Fed tries to walk the tightrope of pursuing economic growth and price stability. I say let the government handle growth through a liberal tax policy and the Fed can unleash the inflation hawk that will soar in to contain the detrimental effects of protracted inflationary expectations.

The best type of strategy for investing in this uncertain environment is coincidently the model that I believe works best under any scenario: follow the trends that are paying off now while keeping an eye on contrarian opportunities. Many hard commodities are off their highs and provide a good entry point for an investor looking for a good hedge to inflation as well as to take advantage of continuing infrastructure growth in emerging markets.