Say Hello to Stagflation

As noted in Tuesday’s update, investors seem to be increasingly preoccupied with the prospect of inflation as well as economic slowdown. This troublesome combination, known as “stagflation,” is not pleasant for anyone. If you are old enough, think back to the early 1970s for an example of what it looks like. 

The signs are adding up. The Consumer Price Index jumped 0.4% in January and is up 4.3% in the last twelve months. This is the highest annual inflation rate in 16 years. Not coincidentally, the Federal Reserve just cut its 2008 U.S. growth projection; the Fed now expects growth of between 1.3% and 2.0% this year. Manufacturing activity is slowing while unemployment rates are rising. It should be no surprise that consumer spending is down as well.

Given all this negative news, it is a bit surprising that the stock market is not even weaker than it is. We have not yet seen a major wash-out event in which even the bulls give up hope. Certain sectors, like housing, have indeed been taken down hard in the last year, but there are still plenty of bullish projections for broad-market growth. At some points these bulls will surrender, and the bottom will be in place. When it will be is anyone’s guess.

So what is an investor to do in this environment? With short-term interest rates low and heading lower, holding cash is not a very attractive option. The inflation factor makes long-term bonds unappealing. Most equity sectors are in downtrends. We see two possible strategies. First, focus on those few equity sectors that are showing positive intermediate-term momentum. It is not a long list: energy, basic materials, precious metals, and transports. Second, maintain positions in the second-tier sectors which have the highest relative strength, such as health care and consumer staples. While they may be weak in absolute terms, these sectors could quickly recover lost ground as the recession deepens.