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Is ’70s-style stagflation returning?

Inflation is rising and the economy is decelerating, but those problems don’t add up to that nasty combination of stagnant growth and out-of-control price increases. Yet.

By Jim Jubak

Stagflation is coming. Lock up your portfolio. We could be on our way to a replay of the 1970s.

That’s the worry among an increasing number of investors as we head into 2008. It’s certainly possible for the year ahead, but it’s unlikely. In this column, I’ll look at what would have to go wrong for stagflation to return and how to position a portfolio if you think stagflation is more of a danger than I do.

The ’70s have a lot to answer for:

  • "Airport," "Airport 1975," "Airport ’77" and "Airport ’79."
  • The Village People and "YMCA."
  • The breakup of the Beatles.
  • President Jimmy Carter and the killer rabbit.
  • Sonny Bono’s bell bottoms.
  • And stagflation, that lethal brew of stagnant growth and high inflation.

In the United States, headline inflation started off the decade at 5.5% in 1970, peaked at 12.2% in 1974 and again at 13.3% in 1979, and didn’t drop below 4% until 1982. For the ’70s as a whole, inflation averaged 7.4% annually. In comparison, inflation in the 1960s averaged 2.5% annually.

Real economic growth tumbled. Subtracting for inflation, the economy grew by just 3.27% on average from 1970 to 1979, quite a drop from the 4.44% average annual growth in real gross domestic product recorded from 1960 to 1969. And in two years during the 1970s, after subtracting for inflation, the economy actually declined in size — by 0.5% in 1974 and 0.2% in 1975.

As you might expect, the 1970s weren’t a great time for investors. The Standard & Poor’s 500 Index ($INX) returned a compound annual 5.9% from 1970 to 1979. With inflation running at an annual 7.4%, an investor in the stock market was losing ground every year to inflation. Bond investors had it even worse: The compound annual return on a long-term U.S. Treasury bond for the decade was just 4.8%, 2.6 percentage points lower than the inflation rate.

So you can understand why the prospect of stagflation in 2008 would send shivers up investors’ spines. How likely is that scenario? Let me break down stagflation into its two parts, the "stag" and the "flation." I’ll deal with "flation" first.

The ‘flation’ part of the equation

Is high inflation coming back? Yes.

The Federal Reserve and the European Central Bank, the two most important inflation fighters in the world, are worried that inflation is too high. Headline inflation, the number the European Central Bank watches, was 3.1% in November in Europe, way above the bank’s 2% limit. In the United States, headline inflation was 4.3% in November.

The Fed’s preferred measure of core inflation — headline inflation minus any increases in volatile food and energy prices — was a lower 2.3%. (Energy prices were up 21% in the month, so leaving them out of the inflation calculation helped.) But even that was above the Fed’s comfort zone.

For the "flation" part of stagflation to set in, those rates have to go higher and create the expectation that inflation is headed out of control.

Unfortunately, higher inflation is coming from every direction you care to look. Normally, the Federal Reserve and the European Central Bank would move to stomp out inflation by raising interest rates. Now, thanks to a weakening U.S. economy and turmoil in the debt markets, the Fed is lowering interest rates instead, and both banks are flooding the financial markets with short-term cash.

China, Russia and other emerging-market economies determined to keep their currencies from gaining against the dollar are creating money to buy dollars, inflating their own currencies, and that money is fueling booms in stock and real-estate markets. Inflation hit 6.9% in China in November, for example. And these countries are exporting some of their inflation in the form of higher prices for developed-world customers such as Wal-Mart Stores (WMT, news, msgs). Demand from these fast-growing economies for raw materials is driving up the price of coal, iron ore, corn, wheat, oil — just about every commodity you can name. A falling U.S. dollar is driving up the cost of everything the country imports, from oil to children’s toys.

Normally, the Federal Reserve could count on a slowing economy to take a bit of wind out of inflation’s sails. But many of the current causes of inflation aren’t linked to the U.S. economy. We could get inflation and slower growth — the definition of stagflation.

How we get to ‘stag’

So what’s the "stag" part of stagflation look like as we begin 2008?

The economy seems to be decelerating rapidly:

  • According to the latest data, released Dec. 27 but dating to the end of October, home prices are falling at a record rate. The S&P/Case-Schiller index of home prices in 10 major metropolitan areas dropped 6.7% from October 2006. That’s a record year-to-year decline, beating the old record of 6.3%, set in April 1991.
  • That decline is feeding into a whopping increase in credit card delinquencies. The dollar amount of credit card debt at least 30 days late jumped 26%, to $17.3 billion, in October 2007 from the same month of 2006, according to an Associated Press study of 325 million individual accounts held by the 17 largest credit card trusts.
  • Retail sales in the just-concluded Christmas shopping season appeared weaker than projected, with growth in same-store sales running below estimates of 2.5%, according to the International Council of Shopping Centers. All this is starting to hit the real economy where it counts: in the unemployment numbers. Initial claims for unemployment, a good gauge for what’s going on in the job market, rose to 350,000 in the week that ended Dec. 22. That left the four-week moving average for initial claims at 343,000. That’s getting worryingly close to the 360,000 level in the four-week moving average that has accompanied recessions in 1990 (362,000) and 2001 (373,000).

But as bad as this news is, it doesn’t add up to the "stag" in "stagflation."

What was so excruciating about the stagflation of the 1970s was the duration of the "stag." Slow or negative growth went on for quarter after quarter. After growing at a 4.7% real rate in the second quarter of 1973, real economic growth turned negative, dropping by 2.1% in the third quarter. The economy then rebounded to a 3.9% real growth rate in the fourth quarter of 1973 before heading into the Dumpster. The economy showed negative 3.4% real growth in the first quarter of 1974, a minor revival to a positive 1.2% growth rate in the second quarter and then three straight negative quarters of 3.8%, 1.6% and 4.7%.

No wonder the bear market in stocks of 1973 and 1974 was so painful. Stocks fell 14.7% in 1973 and then 26.5% in 1974.

Right now, no one on Wall Street is looking for a repeat of that extended slump. Growth is supposed to slow in the first half of 2008 and then pick up, leaving growth for 2008 at 2.3%, according to the Federal Reserve. I think that forecast is too optimistic. The slump in 2008 is likely to last for more than just the two quarters Wall Street expects.

But I still don’t expect a recession in 2008 (see "Why the Fed is running scared") and certainly not anything like the negative growth in five out of seven quarters that the economy turned in from mid-1973 to early 1975. (Officially a recession is two consecutive quarters of negative economic growth.)

Not over yet

What could tip us from slow growth — either the two quarters that Wall Street expects or the three to four that I think is likely (see "Don’t count on a ‘normal’ recession") — into 1970s-style stagnation?

An expansion of the credit crunch from its current victims — home buyers who can’t find a mortgage and homeowners who can’t refinance a mortgage — to corporate borrowers with decent credit ratings. If companies can’t raise capital on decent terms, they’ll cut spending on new equipment and construction, then eliminate plans for hiring, then cut back on buying anything that’s not essential and, finally, fire workers. And then we’ll be on the road to something worse than a couple of slow quarters.

So far, the credit crunch and the rise in effective interest rates has been enough to produce a slowdown, but not a recession and not stagnation. However, we’re not done with this crisis. On Dec. 27, Goldman Sachs (GS, news, msgs) said Citigroup (C, news, msgs), Merrill Lynch (MER, news, msgs) and JPMorgan Chase (JPM, news, msgs) would announce write-downs of $18.7 billion, $11.5 billion and $3.4 billion, respectively, on their mortgage-related portfolios when they report fourth-quarter results in January.

Of course, that’s not likely to be the last of the bad news because the banks and other financial companies with big exposure to the mortgage market are not exactly rushing to embrace their losses. We’re looking at more quarters when bad news will come dribbling out of the big banks. Enough dribbles, and banks could cut lending to all customers even further.

Portfolio suggestions

So how do you position a portfolio as we go into 2008?

Remember that stagflation is possible but not certain. Investors who pay attention to the financial news out of the big banks should be able to keep their portfolios a step ahead of any shifts in the economy’s direction.

Fortunately, many of the investments you’d make to combat stagflation should work pretty well in 2008 even if all we get is a slowdown spread over a few quarters and a step up in inflation. Commodities and energy. Gold, of course. Growth stocks in sectors of the economy that will grow even if the economy slows. And any defensive growth stock with enough pricing power to raise its prices fast enough to stay ahead of inflation.

Some suggestions?

  • The oil drilling and services area, especially companies with big international operations. Worldwide exploration and production spending is set to rise 11% in 2008, according to Lehman Bros.’ annual oil-industry capital-spending survey. Take a look at Schlumberger (SLB, news, msgs), Weatherford International (WFT, news, msgs) and FMC Technology (FTI, news, msgs).
  • Iron-ore and natural-gas stocks. Iron-ore demand is up, and supply hasn’t kept pace. Natural gas is still near a low, and the stocks are just starting to move. Iron-ore plays include Fortescue Metals Group (FSUMF, news, msgs) and Companhia Vale do Rio Doce (RIO, news, msgs), both in Jubak’s Picks.
  • Jubak’s Picks Kinross Gold (KGC, news, msgs) and GoldCorp (GG, news, msgs) will give you good exposure to the classic hedge against rising inflation and a falling dollar.
  • Take a look at the growth stocks I picked in my Dec. 7 column, "5 stocks to profit from a weak dollar," for companies that will be able to outrun stagflation.
  • And don’t forget a dose of pricing powerhouses such as PepsiCo (PEP, news, msgs) and Johnson & Johnson (JNJ, news, msgs). Picks from that group should help you play defense with your portfolio.

I know my end-of-the-year columns have been a bit gloomy — a longer slowdown than Wall Street expects and the possibility of stagflation. A little yule hemlock, anyone?

Enough of the doom and gloom, however. In my next column, I’m going to take a cheery look at how to make money out of the deeply stupid energy bill Congress passed and President Bush signed Dec. 19.

Fourth-quarter performance for Jubak’s Picks

Sometimes I’m happy playing good defense, and that’s the story for the fourth quarter of 2007. For the period, Jubak’s Picks eked out a tiny 0.87% return. But that’s a good result when the stock market as a whole is in retreat. For the quarter, the Dow Jones Industrial Average ($INDU) fell 3.4%, the S&P 500 was down 3.3%, and the Nasdaq Composite Index ($COMPX) retreated 1.8%.

The key for the quarter, as it was for all of 2007, was staying away from the financial and consumer discretionary sectors and overweighting energy. The Select Sector SPDR-Financial (XLF, news, msgs) and the Select Sector SPDR Consumer Discretionary (XLY, news, msgs) exchange-traded funds (ETFs) finished a dismal year by falling an additional 18.5% and 14%, respectively, in the fourth quarter.

By contrast, the Select Sector SPDR-Energy (XLE, news, msgs) ETF was up 36.9% for the year and 7.1% for the fourth quarter. But there were few places to hide in the quarter, as even sectors such as Select Sector SPDR-Materials (XLB, news, msgs) and Select Sector SPDR-Industrials (XLI, news, msgs), which were up 22.2% and 13.5%, respectively, for the year fell in the fourth quarter by 0.05% and 4.2%. The biggest disappointment for the quarter was the technology sector: Select Sector SPDR-Technology (XLK, news, msgs) dropped 0.7% in a quarter when it usually rallies. The sector still gained 14.4% on the year.

It’s great when you get the sector right and back the right stock in the sector, too. That’s what I did with Devon Energy (DVN, news, msgs), up 9.9% in the fourth quarter; Ultra Petroleum (UPL, news, msgs), up 13.1% in the period; Yara International (YARIY, news, msgs), up 43.9%; Jacobs Engineering Group (JEC, news, msgs), up 10.7% since I added it to the portfolio Oct. 30; and Joy Global (JOYG, news, msgs), up 13.2% since my Oct. 30 addition to the portfolio.

Kyith

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