How to Survive (and Possibly Thrive during) Stagflation.
Posted: May 10th, 2011 | Author: Joe | Filed under: Investing, Tips | Tags: Bonds, commodities, Gold, Government spending, Inflation, Investing, Real Estate, Stagflation, Stocks, Tips, UnEmployment | 6 Comments »Stagflation. The dreaded “S” word. Stagflation is loosely defined as an economic environment in which inflation is rising, while economic growth (or wage growth) is stagnant or declining. It’s often characterized by high unemployment, and rising prices (high inflation) – the worst of both worlds.
Stagflation, 70′s style.
Most people who are familiar with the term stagflation will no doubt think of the 1970′s when they hear the word. The 1970′s in America was defined by stagflation, and oil shocks.
There is a common belief among many that stagflation in the 1970′s was caused by oil shocks – rapid spikes in oil price, caused by the OPEC nations, and as this article points out:
In desperation, President Jimmy Carter (1977-1981) tried to combat economic weakness and unemployment by increasing government spending, and he established voluntary wage and price guidelines to control inflation. Both were largely unsuccessful.
Others argue that the very reason those efforts were unsuccessful was because they were in fact the cause of much of the problem. Lutz Kilian points out that 1970′s stagflation was caused by poor monetary policy. Oil shocks didn’t help the situation any, but neither did they cause it.
Increasing government spending, lax monetary policy and rising oil prices… sound familiar?
Stagflation, 21st century style.
Despite Ben Bernenke’s claims to the contrary, real inflation has risen quite sharply over the past year. Gasoline prices alone have risen over 10%, food prices aren’t far behind.
Up until now, Bernenke and company have focused only on “core inflation” which excludes “volatile” areas of spending like food and gas. The problem is that while these expenses are volatile and prone to high degrees of fluctuation, they also happen to be things that people need to buy.
It’s one thing to exclude volatile spikes in situations like 2007-2008, when fuel prices spiked, but then receded. However, when real inflation takes hold, the core inflation numbers become misleading at best, and insulting to the general public at worst. As I write this, inflation by some counts is closer to 10% than the official 2.6%.
Everybody knows they’re paying more for food and fuel, so Bernenke only loses credibility with the general populace when he comes out with statements about inflation being “mild” or “tame.”
The Federal Reserve’s liquidity policy is spurring inflation and even leading some states to seek alternative currency.
John Boland, financial adviser at Maple Capital Management sees inflation as high as 6% by the end of 2011 – and that’s the “official number”, not counting food and gas prices!
Some have sounded the alarm over hyperinflation, but personal incomes are flat , at best and declining at worst. This coupled with high unemployment seems to suggest either depression or stagflation.
It looks to me like we have a little of both: depression in the things we want, inflation in the things we need. Things like cell phones, televisions and computers are getting cheaper while food, gas and clothing are getting more expensive.
So, the stage looks set for a potential encore presentation of 70′s style stagflation. How do you survive stagflation and can you possibly thrive during such a time?
Thriving through stagflation
Looking back at the 1970′s makes it pretty clear that very, very few people got rich after accounting for inflation. In fact, it was considered a victory just to keep pace with inflation and not lose “too much” of your wealth.
The average American was much worse off by the time stagflation ended in the early 1980′s.
Here are some of the ways people were able to maintain their savings, if not prosper at least a little.
Investing
Bonds
Seeking Alpha sums up investing in bonds during stagflation like so:
“During the last stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income. It paid to have your fixed income assets as short as possible.”
Because inflation results in each dollar being worth less than previously and a bond is an agreement to pay back a debt today in tomorrow’s dollars, the bond holder is paid back in dollars worth less than he lent. In effect, having his wealth confiscated.
Treasuries are pretty much in the same boat as traditional bonds here, although you can now buy TIPS (Treasury Inflation-Protected Securities). TIPS didn’t exist in the 1970′s, and they were created as a means to protect the value of your savings from inflation. You can learn more about TIPS and buy TIPS at TreasuryDirect.com. Of course, TIPS are indexed to the official government inflation rate and as we’ve seen above, that’s much lower than the real rate. So your savings are still likely to lose value if held in TIPS.
If you have an investment account, you can also buy shares of the iShares Barclays TIPS Bond (TIP) ETF.
If you do hold bonds, keep your domestic bond duration to maturity short. You may also want to diversify into foreign currency bonds.
Some short-term bond ETFs you could use are the Vanguard Short-Term Bond ETF (BSV) and the iShares Barclays 1-3 Year Credit Bond (CSJ). Similarly, there are a number of International bond fund ETFs to choose from as well.
Stocks
When it comes to picking stocks for inflationary or stagflationary times, pricing power is all important. Pricing power simply refers to a company’s ability to raise prices to maintain profit, and not lose sales in the process.
These are the kinds of companies that produce things people need, or are most reluctant to give up. Think: utilities, energy, healthcare and consumer staples.
Commodities
Gold, silver, oil precious metals and agriculture all tend to rise with inflation.
Most commodities have already risen due to anticipated spikes in inflation with excess government spending and have continued to rise with inflation. Precious metals, for example, are probably not likely to be a money maker this late in the game, but they may be one of the few wealth preserving investments this time around.
Other commodities, like oil and agriculture are less of a pure inflation hedge and probably make sense as long term holdings even without high inflation.
You can buy gold coins, and coffee futures on there own, but you can also invest in broad indexes of these and more through ETFs. This provides added diversification, and will let you capture most of the gains with a bit less risk.
To be clear, ETFs that focus on one type of holding are not really diversified. For example, the ETF GLD is focused solely on gold, while DBP is a broader index in the precious metals category. DBP will reward you for gold rising as well as silver and copper, and punish you less if silver takes a tumble but gold and copper remain stable.
There are also a number of good mutual funds for investing in sector stocks, bonds and commodities. I recommend anyone who is interested in those take a look at the fund on Morningstar and find a highly rated (4 or 5 star) fund.
Housing
Traditionally, housing is a go-to place for protecting your money and riding out inflationary waves. Unfortunately, the bursting of the housing bubble has made it difficult to ride that wave this time around. It’s likely to take along time before housing prices begin to rise enough to alleviate inflation, much less keep up with it.
Real estate will likely be sitting this round of inflation out, so people should buy a house only if it makes sense for them to do so – i.e.: it fits their lifestyle and long term goals – not as an investment.
Cash is king
Cash is king when interest rates rise. This will likely be the case toward the end of this inflation cycle, as it was at the end of the last bought of stagflation. In the late 1970′s – 1982, money market accounts were fairly new and proved to be one of the few safe havens.
The problem is that the Fed has kept rates so low, that your savings will actually lose value in a money market now. Eventually though, even the Fed will have to recognize inflation has risen too far too fast and will be forced to do something about it. What they do is raise rates. Quite possibly, very quickly and quite high. This is bad news for people with variable rate debt (mortgages and credit cards) but great news for people with cash on hand to stash in a money market account.
The trick of course is to make it to these final stages with enough money left to preserve in a money market account.
What if I’m wrong?
Whenever I play fortune teller and try to predict the future, I always ask myself: What if I’m wrong?
I’m no expert, but I do know enough to know I don’t know it all and that puts me ahead of many so called experts. So, here’s what you should do if I’m wrong about my views and opinions on stagflation over the next few years:
DIVERSIFY.
That’s what I plan on doing with my money.
Life is full of “what-if”‘s, the only way to get through those moments is to plan for as many possibilities as we can. I still have much of my portfolio in more traditional growth stocks and bonds. I’m not “all in” on gold. I’m simply leaning more toward the types of investments outline in this article so that in the event that these predictions come true, at least in part, I will be in a position to be less negatively impacted.
As I said, I’m no expert and you should speak with a financial planner before making any big decisions. Gold looks great and oil seems like a no brainer, but their prices have been bid up in anticipation of inflation and you may get caught buying high at this point.
I just think you should be aware of the specter of stagflation as being just as possible as rampant inflation or the “gold bubble” bursting.
You say that the official interest rate cannot be trusted, and that TIPS are indexed to that rate. If that’s true, and real inflation is higher than the official rate, then aren’t TIPS just the new “certificates of confiscation” ?
Very astute observation, Jim. You’ve hit upon a major problem with TIPS: The entire TIPS system is based on a statistic that is manipulated by the government.
That was really beyond the scope of this post, so I decided to write about the problem with TIPS on my own site.
Thanks for the comment!
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In the 70s, those investing in CDs where not making money when compared to inflation. After taxes and inflation the CDs earn nothing or close to it.
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