The Return of Stagflation

Stagflation: a term coined by economists in the 1970s to describe the previously unprecedented combination of slow economic growth and rising prices.

"Many of today's investors were still in diapers during the great stagflation of the 1970s. Those who weren't will never forget the darkest period in modern financial market history."

Stephen Roach
Morgan Stanley Dean Witter

There was an economic nightmare during the 1970s that may just be coming back to cause sleepless nights for American investors: stagflation. Stagflation is the worst of both worlds: inflation and recession. It is characterized by an economy that is contracting while prices continue to rise. Just like Stephen Roach of the mega-brokerage firm Morgan Stanley Dean Witter, many economists and analysts are suggesting that the world economy is headed in that direction for the first time in a quarter century:

"The...economy is facing a period of stagflation in which both growth and inflation disappoint."

David Walton
Goldman Sachs

"The threat of stagflation in Europe is putting a damper on the Continent's equities markets."

Richard Thomson
worldlyinvestor.com

"Baggy pants, John Denver songs, and "Impeach Nixon" bumper stickers. That's what I remember about 1974. Of course, that's probably because I was only five years old at the time. If I'd been a bit older, I might be able to recall phrases like oil crisis, inverted yield curve, and stagflation. Those terms come in handy today, since many analysts fear we may be living a repeat of the 1973-74 economic slowdown, which ushered in a bear market."

Sam Jaffe
It's Starting to Feel a Lot Like 1973-74
Business Week

"We are managing to get ourselves into a stagnant economy with inflation-stagflation-for the first time in very many years."

"Wall Street likes to talk in terms of "soft landing" or "hard landing" for the economy. What it really ought to watch is stagflation."

John Crudele
Stagflation or Inflation-It's Still a Mess
The New York Post

A Brief History Lesson

Up until the 1970s, it was generally believed that recession and inflation could not occur at the same time. A slowing economy was supposed to bring stable prices, so inflation just could not be a problem when the economy slowed. That fact gave central bankers, such as the U.S. Federal Reserve, a sure-fire method for combating high inflation: just employ tight monetary policies until inflation was choked to death. The Oil Crisis of 1973 shattered that myth and resulted in a new word in financial circles: stagflation.

The four-fold increase in oil prices imposed by OPEC in 1973-74 raised price levels throughout the economy while slowing economic growth at the same time. This left policymakers in a quandary. World central banks, worried about a severe economic slowdown, chose loose monetary policies and inflation took off.

"The 1973 Arab oil embargo created a massive price rise and economic dislocation, from Tokyo to Paris to Chicago. The explosion in oil prices ushered in a decade of "stagflation" in which inflation soared while economies stagnated. By the end of the decade, the United States experienced double-digit unemployment, double-digit inflation and double-digit interest rates."

www.stratfor.com
Oil and the Coming Global Economic Slowdown

During the 1970s period of stagflation, a long bull market in stocks turned into a severe bear market.

Stagflation is a 4-letter word on Wall Street because, once it takes hold, it is very difficult to correct. Fiscal and monetary policies aimed at stimulating the economy only exacerbate the inflationary aspect of stagflation. Tight money policies, on the other hand, amplify the stagnating effects of things like high oil prices. Stagflation can also cause other distortions that put policymakers in a no-win situation. For instance, one part of the economy can be growing at the same time that another is shrinking. For instance, manufacturing can fall into recession, while the service sector is still growing. This can mean that wages are growing in one sector at that same time they are falling in another. This creates a serious problem for timing any adjustment of the economy. It can even make it difficult for economists to judge what direction the economy is actually going in.

So, what is the Fed to do? Should the government try to tackle a recession, cutting interest rates and taxes, or should it try to keep inflation low, raising interest rates and maybe even taxes?

Looking to the Future

After basking for years in the warm glow of a combination of steady economic growth and low inflation, the U.S. economy could soon find itself mired in stagflation. We're starting to see some of the ingredients in that recipe showing up already.

• Oil prices have tripled over the past 18 months and don't appear to be headed lower any time soon. In fact, should tensions worsen in the Middle East, prices could still go much higher.
   
• The most widely-watched measure of inflation, the Consumer Price Index (CPI), has been on a slow, but steady, rise all year. Even the core rate, which excludes food and energy, has exceeded Wall Street's expectations this year.
   
• On the other hand, other economic measures are beginning to indicate that the Fed's tightening earlier this year has begun to slow the economy down. GDP is not growing as fast. Durable goods orders and manufacturing output are moderating.
   
• The NASDAQ has been in a bear market for months now and the Dow has been sluggish, suggesting a stagnating economy could be ahead.
   
• Many corporations are starting to report problems with earnings.
   
• The "Yield Curve" has inverted. Just like in 1973, the yield on short-term Treasury securities is higher than that of a 30-year Treasury bond. Usually, higher yields reward investors for taking longer-term risks. In the upside down world of inverted yield curves, which have been an accurate predictor of bear markets in stocks, investors get rewarded for taking on short-term risk. It's a sign of trouble in the future.

Lessons Learned

None of these statistics are signaling an immediate return to the double-digit inflation and economic malaise of the 1970s, but investors should appreciate the fact that, unlike the 1970s, they have the benefit of hindsight. Stagflation is no longer unprecedented. Investors need to prepare now. How? Start by taking a look at what happened in the 1970s during the period of stagflation that occurred back then:

The period 1973-74 saw the worst bear market in stocks since the Great Depression. The Dow fell 45%. The price of gold in London increased from $66/ounce to $186.50/ounce-an increase of 282% in less than 2 years.

There is no guarantee that history will repeat itself. But every investor needs some financial insurance just in case stagflation does return. Gold is uniquely suited to provide your wealth with protection in the event of a recurrence of the stagflation nightmare.

While investors have the opportunity to protect their wealth from the potential onset of stagflation, Washington and Wall Street better start noticing that we are headed down that road. The federal government is lulling the country to sleep with a false sense of security by playing games with inflation numbers. This may be a great tactic for getting incumbent politicians elected, but it will only magnify the effects of high inflation when they become more apparent. Unlike in 1973, when tensions in the Middle East peaked early in the stagflationary cycle, it is likely that conditions in the Middle East will get worse from this point. This means that, despite the fact that oil prices have already tripled in the recent past, they could go much higher still. Meanwhile, Wall Street wants you to believe that oil price hikes are no longer a major problem for the economy. History has been very unkind to those who ignore the warning signs of trouble when they appear.

Since you cannot depend on Washington and Wall Street to protect your wealth, you need to protect yourself. Protect yourself with an asset that does not depend on anyone's promises: GOLD.