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Our Next Economic Hurdle In The US: Stagflation

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EDITOR NOTE: The Fed is keeping interest rates at zero hoping, among other things, to increase demand for borrowing as well as spending. Yet, Americans are not spending due to uncertainties surrounding not only the economy but on the continuing rise of pandemic cases. With low demand, you may get more job losses, lower income growth, and decreased production With decreased production, you get dwindling supply and higher prices. What happens if both factors combine and intensify? You get stagflation--slow growth, high inflation, and low employment. Get ready, because it's one among many viable paths toward which we’re all heading.

The shock to the economy from COVID-19 has been roughly of the same magnitude as the Great Financial Crisis (GFC) of 2008. However, while the GFC was a shock to credit, the pandemic has been a shock to income, for both individuals and businesses.

Like the Great Financial Crisis, the Federal Reserve has responded with trillions in stimulus. However, the challenges presented by COVID vary from the GFC in several ways.

For one, the Federal Reserve can not simply fix the problem by restoring credit and flooding the financial system with liquidity. The Federal Reserve must also restore demand and income. The latter is a much more difficult problem to tackle than easing monetary conditions. And no matter how much liquidity is restored to corporations, the Federal Reserve can not force consumer demand higher.

The adage "you can lead a horse to water, but can't make him drink" comes to mind.

Shutdowns, quarantine and outright fear caused consumers to pull back demand indefinitely at the same time companies pulled back supply in what looks to be a long-term impairment to the global economy. While equity markets are back to pre-COVID levels, the effects of COVID remain, and so does the uncertainty over how businesses, and consumers will spend in this post COVID world.

The feared eventual result is lower supply leading to higher prices, and lower demand leading to job losses. Combine the two, and we get stagflation: a state of slow economic growth, high inflation and high unemployment.

Is the U.S. economy in a state of stagflation now? America is indeed experiencing high unemployment, and higher prices on key consumer items (rent, food, and transportation). While unemployment has fallen from 14.7% in April to 7.9% in September, the rate is still more than double the 3.6% in January of 2020 prior to the pandemic. The devastating effects of COVID will continue to linger in the economy for years to come weighing on growth, causing stubbornly high rates of unemployment.

And the economy, while bounding off the recession bottoms, is widely predicted to slow down in coming quarters.

Oil Crisis of the 1970s vs. COVID

The most similar example of stagflation in history is the 1970s oil crisis, when Arab nations starved America of oil in retaliation for its support of Israel in the Yom Kippur War. Like COVID, the oil crisis came as a sudden shock to the economy. The effects of a sharp increase in oil prices caused job layoffs, at the same time businesses had to raise prices due to higher energy costs leading to stagflation.

Oil prices rose 400%, raising prices on everything (inflation) but lowering demand due to the higher costs, leading to unemployment. The higher energy prices also meant a higher cost of living, which led employees to demand higher wages. Wage inflation pressured businesses, which led to more inflation and reduced hiring, exacerbating this negative feedback loop.

Fast forward to today.

While employment numbers have collapsed, the cost of major items are indeed rising. Here are a few key stats on increasing cost indicators:

  • The average lease price for every apartment type – from studio up to three-bedroom – is on the rise year-over-year, according to Studio apartments are showing the largest increase at 5.4% percent, followed by two-bedroom units, up nearly 4.5% from last year. One-bedroom apartments increased by a more modest 1.6% on average.

  • Used-car prices continue to soar higher, according to Kelley Blue Book, as low borrowing rates and an aversion to public transportation have driven demand.

  • Food prices are surging; export prices for rice from Thailand are at a six-year high, and Chicago Wheat Futures are near highs for the year as countries rush to secure supplies at the same time supply chains are being disrupted.

While the shock from COVID has caused millions of layoffs, the Fed has simultaneously flooded the financial system with trillions of dollars and signaled rates at 0% for longer, which has sent stocks soaring and buoyed an already expensive real estate market. The monetary stimulus, coupled with fiscal stimulus aimed at propping up demand, will push up prices at the same time unemployment sits around 7%.

While the financial markets continue to race to breathtaking new highs, those of us faced with the real economy endure higher prices and high unemployment.

Inflation? What Inflation?

Many will balk at the mention of inflation. That's easy to do. The United States, and most of the world, has been in a state of persistent deflation since the late 1970s.

But many of the structural factors that supported deflation are either no more, or turning.

The Volcker response to inflation, which aggressively raised interest rates to crush inflation, has been completely reversed. The Fed funds rate effectively is at zero and likely to stay there regardless of real rates (the nominal rate we borrow and save at, minus the rate of inflation) for years.

The move to globalization – which led to lower production prices – has largely reached its limit. Reversing globalization has been a top priority of the Trump administration, which is evident in his policies on China, specifically, the return of production back to the U.S. There is little doubt that higher cost production in the U.S., and the disruption of supply chains, is inherently inflationary.

Another priority is trying to overhaul the H1B visa program, where new rules call for entrants to be paid almost double the previous wages in a push to have U.S. companies "hire American."

Also, the explosion in productivity due to technology has been largely deflationary. And while this wave of deflationary technology continues, I believe the rate of technological gains moving forward will decrease, and will be less deflationary moving forward. Just look at the Department of Justice, which has begun its antitrust review of America's tech giants. Moving forward, increased regulation, scrutiny and taxation of the tech sector is a real possibility.

Will Fed Stimulus Solve the Income Problem?

Contrary to the 2008 financial crisis, during which central banking systems like the Fed printed money to restore credit markets, the COVID-19 pandemic has caused central banks to print money to restore credit and restore income.

The fiscal response (governmental spending) required to restore income is far more complex than a monetary response (what the Fed does). While monetary stimulus increases the availability of money at financial institutions, a fiscal response aims to increase the demand for that money by spending money directly in the real economy, not the banking system.

The massive money printing by the Federal Reserve in response to COVID has been successful in restoring financial markets. The major blue-chip indices are all within a couple percentage points of all-time highs.

But the real economy still has a gaping hole in demand that has yet to be reconciled. For instance, TSA travel checkpoint numbers are trending at about 30% to 40% of their pre-covid levels. This has implications for everything from restaurants and hotels to gasoline consumption.

This "dislocation" between the financial markets and real economy is the danger to portfolios moving forward. We risk a scenario in which Fed stimulus reaches its limits, then the market eventually realizes this dislocation – that stock prices don't support the profits their underlying companies generate – and responds by selling off those assets. That would only exacerbate problems in the economy by signaling to companies and consumers alike to pull back purchasing and investment even further.

At what point does the market look at the possibility of stagflation and "reprice" the financial markets to reflect the real economy?

I don't believe we need full stagflation for a repricing to occur – only an acceptance by market participants of the possibility that the Fed is going to allow the economy to finally reconcile this gaping hole in the real economy.

The reason the market has been able to ignore all of the real damage to the economy, is because the Fed has signaled that they will do whatever it takes and wave after wave of new stimulus is in wait. This has had a perverse effect as the stimulus continues to send asset prices higher, while not solving the demand/employment problem.

Your Portfolio in a Post-Covid World

One approach to consider is the Adaptive Asset Allocation (AAA) model. This model is actively managed and weights the portfolio according to the economic cycle.

Depending on the severity of stagflation in the economy, the strategy will weight the allocation appropriately to these five asset classes:

  • Stocks

  • Real estate investment trusts (REITs)

  • Gold

  • Treasuries

  • Treasury Inflation-Protected Securities (TIPS)

Should inflation start to creep higher, the portfolio increases exposure to REITs, TIPS and gold. The equity portion of the portfolio will consist of economic sectors adjusted to the business cycle. In the current environment, the equity portion would consist of companies doing well in this new remote workforce regime, technology stocks and healthcare. As a vaccine is developed, and the world emerges from COVID, the equity allocation would rebalance to infrastructure, energy and transportation names.

This type of strategy is ideal because it allows investors to stay invested regardless of the state of the economy, elections and other risks.

Bottom Line

The financial markets, thanks to Fed intervention, have largely decoupled from the real economy. Portfolios – especially those overweight to passive index funds and technology – risk a severe "reconciliation" between the financial economy, and the real economy.

A very real catalyst for said reconciliation is the possibility for U.S. stagflation. Additionally, even the slightest sign of weakness from the Fed to further stimulate the economy, or an indication that they may raise rates could cause this financial reckoning.

Investors are best-served by diversifying at least part of their portfolios away from passive strategies to funds that can actively manage around the risks (and opportunities) that stagflation may present.

Originally posted on Yahoo! Finance

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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