Stagflation is Knocking on the Door

Investopedia defines stagflation as a condition of slow economic growth and relatively high unemployment – a time of stagnation – accompanied by a rise in prices, or inflation.  Given the economic data reports that I have observed thus far in 2011 (not just over the past two weeks), I believe that it is fair to say that stagflation is knocking on the door.

To understand my current stagflation forecast, consider the numerous data points that point to a slow, future economic growth and a stalling economic recovery:

  • UNEMPLOYMENT – A national U-3 unemployment rate that remains above 9% and a national U-6 unemployment rate (which counts not only people without work seeking full-time employment as seen in the more publicized U-3 rate, but also counts marginally attached workers and those working part-time for economic reasons) that remains above 16%.
  • INITIAL JOBLESS CLAIMS – A continued trend of weekly initial jobless claims of 400,000 or greater.   The four week moving average of the key data point currently stands at 402,500 according to the United States Department of Labor.  Many analysts believe that claims below the 400,000 point towards a stable labor market.  Hence, reports that show claims below 400,000 are generally received positively by the market and we have only seen 8 reports showing claims below 400,000 in a given week over the first 33 weeks of 2011.
  • GDP GROWTH – Gross Domestic Product (GDP) growth rates that have been revised downward for both the 1st and 2nd quarters; 0.40% and 1.30% respectively, of 2011.   According to Trading, GDP Growth in the U.S. has experience a quarterly average gain of 3.28% from 1947 until 2011.
  • HOU.S.ING – The National Association of Realtors (NAR) recently reported a 3.5% month-to-month fall in existing home sales and suggested that 2011 is shaping up to be the worst year in terms of mortgage applications for new home purchases in over 14 years.   Perhaps even more concerning, according to the NAR, 16% of all housing contracts that were signed in July were cancelled.  This rate is above the historic average of 10% and suggests to me that the few buyers that were in the market perhaps got cold feet given the heighted concerns with respect to the economy.   Longer term, housing may be one of the areas that may help to pull the U.S. out of its economic malaise but its success remains dependent on the other three data points listed above.
  • PHILLY FED SURVEYS – One part of the August 2011 Business Outlook Survey conducted by the Federal Reserve Bank of Philadelphia showed that the business activity index for the Mid-Atlantic region dropped to -30.7 from +3.2 in August.  The reading was well below economists’ expectations for a reading of +3.7 and was the biggest month-over-month drop in the index since October of 2008 and the index now stands at its lowest level since March of 2009.  The plunge in the headline index of the Philly Fed survey, to -30.7 in August from +3.2 in July, was simply awful. It leaves it at a level last seen in March 2009, when the U.S. was last in recession. The new orders index plunged (-26.8 vs. +0.1), the shipments index dropped (-13.9 vs. +4.3) and the employment index fell (-5.2 vs. +8.9).

Couple these anemic, economic growth highlights with rising commodity prices; such as wheat, oil, gasoline and precious metals, and recent reports of an increase in core inflation readings, and it is hard to argue that stagflation is not upon us or at least worthy of further consideration.   In my view, even if demand for commodities from Developed Markets softens for the balance of the year, demand for Commodities from Emerging Markets should help to compensate and prevent any material reductions in Commodity prices.

I would also contend that there is a higher probability of the economy entering a period of stagflation than entering a double-dip recession as I still believe that the U.S. truly has not emerged from the most recent “Great Recession.”   Hence, a continued lack of economic growth would suggest a continuation of the current recession as opposed to a dip back into a new recession.

As opposed to allowing fear and emotion to drive critical investment decisions, we, at Hennion & Walsh, believe that investors would be wise to revisit their asset allocation strategies with their financial advisors and look to incorporate a wide range of asset classes, such as Domestic Equities, International-Developed Market Equities, International-Emerging Market Equities, Fixed Income, Alternative Investments and Cash & Cash Equivalents, as appropriate, to help ensure that their portfolios are structured to both accommodate an economy leaning towards a period of stagflation and to weather anticipated periods of further market volatility.