By Frank Lugo, Senior Investment Officer
The first three terms above are probably familiar, but stagflation may be new to some. The word, which merges stagnation and inflation, originated in the hyper-inflationary days of the 1970s. However, this term has been popping up more frequently in recent news. What does it mean and how should we prepare for the possibility of its arrival? First, let’s quickly review the difference in the four terms:
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Inflation: Inflation is the rise in prices of goods and services with a corresponding decrease in purchasing power. This can occur when spending increases relative to a limited supply of goods in the market – in other words, too much money is chasing too few goods. Increases in the money supply, as measured by M2 (M1 plus some less liquid assets), historically have been problematic.
So, why haven’t we seen inflation in the last five years where M2 money supply increases have been most dramatic? This is partly because the velocity of money (how many times dollars turn over in the economy) is at an all-time low since the 1960s. Critics of the formula “gross national product (GNP) over M2” point to growth of the denominator in the equation as partly responsible for the lower calculation. Improvements in productivity and technological innovations play a part, as well.
- Deflation: Deflation is when consumer spending and asset prices decrease over time and purchasing power increases. While this sounds positive, it could lead to a “deflationary spiral.” A deflationary spiral is a downward price action to an economic crisis that leads to lower production, lower wages, decreased demand and still lower prices. The negative feedback continues, making a bad situation worse. In the Great Recession of 2008, the U.S. began to experience deflation when the inflation rate fell below zero, marking a measurable decline in the cost of goods and services.
- Disinflation: Disinflation is a slowing of the pace of inflation. Unlike inflation or deflation, which refer to the direction of prices, disinflation refers to the rate of change in the inflation rate. Disinflation becomes dangerous when the rate of inflation falls near zero, as it did in 2015, raising the prospects of deflation.
- Stagflation: Stagflation refers to an economy experiencing a simultaneous increase in inflation and a stagnation in economic output. It was first recognized in the 1970s when many developed economies experienced rapid inflation and high unemployment caused by an oil embargo that quickly elevated gas prices. Plus, the U.S. moved away from the gold standard for the dollar, which resulted in a weaker dollar that caused U.S. import prices to increase.
Why is stagflation dangerous?
When economic growth slows, unemployment increases, demand declines, and prices are not likely to rise for goods and services. This situation is exacerbated when you tack on a monetary system experiencing excess growth in M2 money supply and the perception of a weaker dollar that is causing import prices to inflate. A weak dollar increases the need for more dollars to buy the same amount of imported goods.
The solution in the 1970s and 1980s does not seem like a viable choice today. Then, Chairman Volcker ended stagflation by bumping the fed funds rate from 7.65 percent on August 1, 1980, to 22 percent on December 31, 1980. The rate eventually peaked at 22.36 percent on July 22, 1981 – a 1,400+ basis-point-jump in four months. At current national debt levels, this is not an option.
The results of these bumps were: 3-month, 6-month and 12-month T-bills peaked at 17.14 percent, 15.93 percent and 15.21 percent, respectively, from late 1980 into third quarter 1981. Bank CDs were also posting double-digit rates, but they were in the low 20s. The inversion of the curve from T-bills to 30-year Treasury was indication of a peak in the rate cycle. A strategist from Merrill Lynch recognized the signs and made the call to buy zero-coupon Treasuries. As these bonds have the greatest potential for capital gains in a declining interest rate environment, this strategist’s observation paid handsome returns.
Investments and strategies you may want to consider include:
- Cushion bonds using Treasuries and Agencies: Higher coupon bonds at premium prices provide great cash flow opportunities to reinvest interest distributions, while the yield to maturity (YTM) assumes reinvesting distributions at the stated yield. Anything below or above reduces or increases returns. Plus, the higher coupons can improve your weighted average cost (WAC) on the portfolio, thereby mitigating price declines to the portfolio if interest rates increase.
- 10-year and seasoned 15-year mortgage-backed securities (MBS): Look for high coupons, priced at a premium, with short-stated finals. As interest rates move up, these securities extend, thus amortizing the premium over a longer period, which results in higher returns. Add an MBS with a stated final of 7-13 years and you mitigate the extension risk of a longer term and the potential for big price declines.
A couple potential strategies are provided above. To discuss additional alternatives with a member of the Brokerage Team, contact us today.
All securities are offered through CU Investment Solutions, LLC. The home office is located at 8500 W 110th St, Suite 650, Overland Park, KS 66210. CU Investment Solutions, LLC registered with the Securities and Exchange Commission (SEC) as a broker-dealer under the Securities Exchange Act of 1934. CU Investment Solutions, LLC is registered in the state of Kansas as an investment advisor. Member of FINRA and SIPC. All investments carry risk; please speak with your representative to gain a full understanding of said risks. Securities offered are not insured by the FDIC or NCUSIF and may lose value. All opinions, prices and yields are subject to change without notice.