Stagflation – July 2006

July 25, 2006
Dow Jones Average: 11,104
S&P 500: 1,269




Of all the conditions that can afflict the economy and the stock market, stagflation is one of the most feared. Stagflation is the term used to describe a weak, stagnant economy accompanied by higher than normal inflation. While an outright 1930’s style depression would be worse for stocks, bouts of stagflation inevitably erode stock prices. It is a rare condition, because it is difficult to maintain price inflation in a soft economy. Stagflation occurred in the 1970’s, and some analysts believe that conditions are once again conducive to this peculiar condition.

Inflation has been building in intensity over the past few years, fueled by cheap money, surging home prices, and rising commodity prices. The Federal Reserve Board can choose to promote inflation through a loose monetary policy or restrain inflation simply by making money expensive to borrow. Under its former chairman, Alan Greenspan, the Fed decided to set a policy of historically low interest rates in an effort to shorten the recession of 2001-2002. The low rates touched off a multi-year housing boom that is only now beginning to cool down. Trillions of dollars in new money, borrowed against real estate, have flowed into the economy, making widespread inflation more likely. When a major, widely held, asset class, such as homes, skyrockets in value, the entire economy is reset at an inflated level. Suddenly three dollar a gallon gasoline doesn’t seem like much when compared to other prices, particularly home prices. Inflation has a tendency to spread from one sector of the economy to another, and from prices paid to wages earned.

Two years ago it appeared that the U.S. economy could grow at a brisk pace, propelled by low interest rate money and tax cuts, without causing an acceleration of inflation. Some economists attributed this unusual situation to the deflationary impact of cheap goods and low cost capital, pouring into the U.S. from China and other Asian countries. Asian banks have been big holders of the low interest rate mortgages provided to homebuyers in the U.S. It seemed to be a virtuous circle of low cost money coming in to help sustain our housing boom and cover budget deficits, while cheap goods kept inflation in check. It has now become obvious that rapidly growing, emerging economies also contribute to inflation, by competing for resources such as oil, scrap metal, copper, and dozens of other materials.

The Federal Reserve Board has decided that it needs to squelch inflation before it becomes entrenched. The new Fed chairman, Ben Bernanke, said recently that core inflation had moved above the Fed’s comfort level. That single statement sent financial markets reeling. Investors know that as the Fed raises interest rates to combat inflation, the probability of an economic slowdown becomes greater. Even as the economy falters, the rate of inflation does not change immediately. Higher prices for energy and real estate continue to pass through the system, affecting rents, and the price of many other goods and services. The net result can be stubborn inflation in the face of a slowing economy, which is the definition of stagflation.

Current Strategy

Stock markets throughout the world weakened in the second quarter of 2006, as it became clear that the U.S. Federal Reserve Board was not done with its policy of raising interest rates. Volatility has increased noticeably, as 200 point up days alternate with triple digit losses. Money market funds and short term bonds have outperformed most equities at this juncture in the year. The weakest stock groups have been retailers and other sectors dependent upon consumer spending. Analysts have been predicting a consumer led slowdown for years, based on high national debt levels, a low savings rate, and the usual digestion period that follows heavy consumption. These predictions have been premature, but may be right this time, as consumers contend with the additional burdens of higher interest rates, and rising prices for many goods and services.

Our focus this year has been preservation of capital, securing profits, and building up cash reserves for future equity purchases. Many holdings reached our price objectives as market conditions were favorable earlier in the year. In retrospect, our only regret is that we did not sell even more holdings. A few positions, such as 3M, went up nicely in the first quarter of 2006, and have since retraced all of that progress.

We are maintaining positions in more economically defensive holdings such as medical, food, and consumer staples. In mid-June we put money into companies that have large natural gas reserves. While natural gas demand is affected by the weather and short term fluctuations in economic activity, over the long term it is a necessary, cleaner fossil fuel. We are currently considering a number of technology companies, including some that have been profitable holdings for our clients in the past.

We are executing our fixed income strategy as the Fed raises interest rates. Two years ago we decided to buy some shorter term bonds, if and when rates moved from one percent back to the five percent level. Rates finally reached five percent in the second quarter of 2006, and we carried out the first phase of our plan by purchasing treasury bonds that mature in 2008 and 2009. We are planning to buy more bonds, of slightly longer duration, if the Fed continues to hike rates. When constructing a bond portfolio we consider the reliability of the bond issuer, the yield, and the risk of capital erosion due to inflation.

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