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Best Asset Classes for Stagflation

By Jim Fink on February 23, 2010

“The mostly likely scenario is some sort of stagflation. I ask anyone to give me an example of an economy beefed up by huge amounts of quantitative easing that did not inflate tremendously when or if the economy improved. I think what we’re doing now will either fail, or it will result in unbelievably high inflation – and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening.”

This quotation from the summer of 2009 is not from some “sky is falling” crackpot but none other than Julian Robertson, the now-retired founder of Tiger Management, one of the first and most successful hedge funds in history (31.5% compounded annual gross returns between 1980 and 2000).

Inflation Bet

He has put his money where his mouth is by purchasing five-year put options on long-term treasury bonds. He’ll make a lot of money if bond prices fall, which will only occur if inflation and interest rates go up. Betting against him probably is not wise.

Good Track Record

I take him seriously not only because of his obvious investing prowess, but because he also correctly forecast a “doozy of a recession” back in October 2007, way before anyone knew the economic horrors that awaited us in 2008. In fact, everyone was giddy because the Dow Industrials and S&P 500 had hit an all-time high just a week before.  What a great call!  Anyone who had heeded his advice and gotten out of equities at that time would be sitting pretty today.

Evaluating the Economic Data

Despite my admiration for Robertson, I am a rubber stamp for no one, being an independent sort. The stock market has been in a rip-snorting bull market for almost a year now, rising by an astounding 64% from the low. Isn’t the stock market a leading economic indicator? If so, then it is indicating that the economic recovery is sustainable and just fine.  Of course, you cannot forget Nobel prize-winning economist Paul Samuelson’s famous saying that the stock market has predicted six of the past four recessions, so the stock market signal could be false this time.

I like to view the economic data for myself before reaching a conclusion, so I was intrigued by the recent government inflation data for January:

Inflation Gauge

Month-to-Month Change

Compared to M/M Consensus

Year-over-Year Change

Producer Price Index (PPI)




Consumer Price Index (CPI)




Producer prices rose much more than expected and consumer prices rose less than expected. Why the disparity? Producer prices are more sensitive to commodity prices (the input for finished products) that are based on global demand and foreign exchange rates, whereas consumer prices are much more influenced by domestic unemployment and wage rates. PPI increases are often considered leading indicators of CPI increases because businesses try to pass on their cost increases to consumers in order to preserve profit margins. But regardless of what it costs to produce something, consumers won’t pay the cost if they can’t afford it. 

Inflation or Deflation Ahead?

So the question remains: will skyrocketing producer prices cause CPI to increase or will a depressed consumer cause PPI to calm down?  The issue comes down to which is more likely, deflation or inflation?  

Some (like Robertson) come down squarely on the side of inflation but realize that it won’t happen right away; the U.S. government stimulus money authorized in 2009 will need time to be fully spent and consumers will need time to feel secure enough to start spending again at a normal pace.

On the other side of the equation are those who argue that the government stimulus is not large enough, will only temporarily stabilize the economy, and that a massive debt overhang and structural unemployment will prevent inflation from taking hold despite the huge increase in money supply.

We’re not going to be able to settle this timeless debate today, so I’ll just throw out some data points that support each position.


  1. Massive increase in the money supply of $1.7 trillion. The Federal Reserve has already purchased $300 billion of treasury securities and by the end of March plans on completing the purchase of $1.25 trillion of agency mortgage-backed securities and $175 billion of agency debt securities. When I say purchase, I mean “print money.”   
  2. Massive federal budget deficits of $1.4 trillion in 2009 (9.9% of GDP) and an even larger $1.6 trillion proposed for 2010 (10% of GDP, the largest percentage level since World War II and relatively more public spending than occurred during the Great Depression of the 1930s). Total national debt is now $12.4 trillion, or 87% of U.S. GDP. Spending so much more than revenue receipts requires either increased borrowings, which would cause interest rates hikes, or the printing of even more money than the Federal Reserve has already done.
  3. China, the second-largest holder of U.S. government debt, reduced its inventory of U.S. debt by $34.2 billion in December, the largest drop on record. Continued lower demand for U.S. treasuries would force the government to increase interest rates, which would cause bond prices to decline and government spending to go up even more, which would require even more money printing (see above).
  4. In January, the U.S. Treasury offered for sale the largest amount of 10-year inflation-protected bonds (TIPS) in five years to satisfy the inflation concerns of China and Japan (the largest holder of U.S. debt). Since the sale occurred at a breakeven rate between TIPS and regular bonds of 2.49%, the government will come out the loser if inflation rises by more than this amount over the next 10 years (a good bet in my opinion).
  5. Perhaps most importantly, the Economic Cycle Research Institute’s “Future Inflation Gauge” hit an annualized growth rate of 37.6% in January, which strongly signals inflationary pressures are increasing.


  1. Last fall, M3 money supply declined at an annual rate of 6.5%, the largest contraction since the Great Depression. This occurred after the economic stimulus package was enacted.
  1. In February of this year, the consumer confidence Present Situation Index fell to its lowest level in 27 years.
  1. U.S. new home sales plunged by 11.2% month-over-month in January to 309,000 annualized units, a record low. Not just volume, but prices continue to fall, with the S&P/Case-Shiller U.S. National Home Price Index falling 2.5% in the fourth quarter compared to the year-earlier period. Just think about that: the fourth quarter of 2008 was in the teeth of the stock market crash and yet home prices in the fourth quarter of 2009 were even worse.
  1. The default rate on commercial mortgages more than doubled in the fourth quarter of 2009 and is expected to rise even higher in 2010 and 2011. As one economist put it: “The level of distress continues to rise” and endangers the ability of small regional banks to make loans, which have higher concentrations of commercial mortgages. Another 250 banks are expected to fail in 2010 alone, which is more than the 181 banks that have failed so far since 2007.
  1. The National Governor’s Association says announced this month that the fiscal year starting in July will be “the most difficult to date.” States, which must balance their budgets every year by either increasing taxes, borrowing, or cutting spending, face a $19 billion budget shortfall for the remainder of this fiscal year and a $54 billion shortfall next year.  Without additional federal aid, the Center on Budget and Policy Priorities estimates that state budget cuts will cost the economy 900,000 jobs next year. Some states, like California and Illinois, are almost broke. Check out as an example.
  1. Nobel prize-winning economist Joseph Stiglitz says the U.S. recession is “nowhere near” an end. Similarly, Paul Krugman, another Nobel Prize winner, warns that the economic recovery will fail without a second federal stimulus package. Other economists at the World Economic Forum in Davos, Switzerland made similar pessimistic conclusions this past January.

Where to Invest

Depressing stuff, and both the inflation and deflation arguments make sense. You never know, but I’ve got to believe that a middle-ground forecast of stagflation might just be the right call.  If so, what are the best performing assets classes for such an environment?  I see five major themes.

Commodities. As this month’s PPI and CPI report suggest, inflation may only make it to the producer level. Commodities are needed by the entire world and are not held hostage to the cash-strapped U.S. consumer. Companies that produce energy, fertilizers, gold, and base metals (e.g., iron ore) should benefit. Example: Bunge (NYSE: BG), a Personal Finance selection.

Foreign Emerging Markets. The economic debt problem is concentrated almost entirely in the U.S. and the Europe. Asian tigers like China and India have almost fully recovered and growth remains strong.  Companies in these emerging markets should do well regardless of what happens here. Furthermore, a weakening U.S. dollar will boost foreign investment returns for U.S. investors. Example: ishares MSCI Malaysia ETF (NYSE: EWM), a Silk Road Investor recommendation.

Large Multinationals with a Competitive Advantage. In times of economic distress, only the strongest survive.  In fact, companies that provide essential services (electricity, water, corporate productivity, food, health care) can prosper as weaker players go bankrupt, allowing them to pick up market share and raise prices. Example: IBM (NYSE: IBM), a Personal Finance selection.

Dividend Stocks. Unlike bonds, the payouts of dividend-paying companies can grow especially if the company’s business benefits from inflation. Furthermore, cash dividends provide a cushion if the stock market tanks and can accelerate a price recovery by being reinvested at low share prices. Example: Southern Company (NYSE: SO), a Utility Forecaster pick.

Small-Cap Growth. Whereas large cyclical companies are more dependent on the overall economy for growth, the best small companies can grow in any market environment, especially if they offer a disruptive new technology. Example: American Superconductor (Nasdaq: AMSC), a Portfolio 2020 recommendation.

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