Heading for stagflation?

01 October 2011 - Charles de Kock

The world is in a proper economic mess. Despite zero interest rates, massive fiscal deficits and unprecedented use of unconventional tools such as quantitative easing, the global economic recovery is faltering. Financial markets have become increasingly volatile as investors react to each and every new data point and failed attempt of policy makers to deal decisively with the sovereign debt crisis in Europe.

Historical background

‘To know where you are going; it is useful to know where you have been’ is a much used expression to convey that a sense of history is necessary to understand the present. One thing that economic history teaches us is that economic cycles are normal; downswings follow upswings – not with perfect predictability of extent or duration, but cycles occur naturally in the economy. The graph below shows the average expansion measured in months in the US since the mid- 1800s. It is clear that the durations of upswings have been extraordinarily long in the recent past. These continuous years of economic expansion led some observers to even speak of the ‘end of cycles’ and gave the Federal Reserve Board (Fed) credit for managing policy much better than in the years before.

It is our view that the fear of suffering a recession made the Fed keep policy too loose for too long. The availability of almost unlimited amounts of cheap goods from China, and other previously closed parts of the world, ushered in a long period of unbridled consumerism without the normal negative inflationary effects. Central bankers kept interest rates very low in the absence of goods’ inflation and bankers happily extended loans to vast numbers of poor credit risk borrowers during these boom times.

 

The extended period of individuals living beyond their means was financed by debt. A lot of which went to finance property. And when the property bubble finally burst banks were left with massive amounts of bad debts. The financial crisis of 2008 then followed and it is from this hangover that the world has not yet escaped.

The deep recession led to sharp drops in government revenues, and the resultant massive fiscal deficits have left many governments virtually unable to service their debt.

How can governments get out of the fiscal mess they are in?

1. Grow the economy

The one way is to grow the economy at all costs. This means keeping interest rates at zero and keeping the fiscal deficit very high. The hope is that by expanding the economy, revenue will naturally rise and only then can a start be made at normalising economic policy. The US certainly tried to go this route, but the shift in the balance of power between the Republicans and Democrats has put paid to this strategy being followed to its full extent. In Europe this ‘go for growth’ option is not feasible as bond investors have signalled their unwillingness to buy more bonds of the highly indebted nations.

2. Tighten fiscal policy

The countries that cannot access more debt have no choice but to follow the more painful route of fiscal tightening. This means spending less and taxing more. This is a very unpopular route for politicians but one that has been forced on countries with the worst fiscal balances such as Greece, Portugal, Ireland, Italy and Spain. Tighter fiscal policies in these countries will almost certainly push them right back into recession. Some very tough policy decisions need to be taken in these countries including extending the working age, reducing pension benefits, paying civil servants less and enforcing tax laws fully.

3. Political muddle through

Politicians of course want to remain popular and get reelected when their terms in office expire. They will therefore try compromise solutions and sometimes just plain inactivity hoping for the best. The German voters do not want their taxes to be used to bail out the sick European countries and will not re-elect Ms Merkel if she does. But without German support the euro will fall apart, with dire consequences for all – including Germany. Thus some form of a compromise will have to be made.

Our view is that the euro will hold, but with the more indebted nations ceding some fiscal authority to a central European treasury – probably under the leadership of a German official.

The real basket case of Greece will in all likelihood have to restructure its debt and may even opt out of the euro. If the larger countries such as Italy and Spain also falter, the impact on European banks will be catastrophic. The relevant authorities will have to come up with a plan that ensures the larger nations remain in the euro.

Stagflation unfortunately a very real possibility

Research shows that following a deep financial crisis economies take a long time to recover to the high growth rates experienced in the years leading up to the crisis. We believe that we are in such a period of sluggish economic growth. Households are repairing their balance sheets and will not be tempted back into debt before they feel comfortable in their own financial health. Interest rates are therefore likely to remain very low for a long time as this period of balance sheet repair takes place.

For governments it also means fiscal deficits will remain large as revenue will just not rise until economic growth is more robust. In order not to get runaway deficits government spending will therefore need to be kept in check. Politicians are notoriously impatient and are likely to try and force growth sooner to help their election campaigns. The loose policies followed are in our view still likely to lead to inflation somewhere down the line.

We are consequently of the view that a period of stagnant economic growth combined with some inflation is lying ahead. Economists have dubbed such an outcome ‘stagflation’.

How to invest in a stagflation period?

Income earning investments (cash and bonds) tend to earn very little as interest rates are deliberately kept very low and in all likelihood below the rate of inflation.

On the other hand, growth assets such as property and equities have the headwind of sluggish economic growth to contend with. Earnings growth therefore also struggles during a stagflation era. A period of low returns is therefore to be expected.

But one need not totally despair. There are many very good businesses with strong balance sheets and the ability to pass cost increases on to customers. These businesses should be able to grow their earnings even in tough times. It is our task as fund managers to find these winning companies. The added good news is that, in our view, many quality businesses trade at attractive valuations and have the ability to pay out handsome dividends, in many cases greater than one would earn in cash or bonds. Our balanced portfolios own inflation-linked bonds, high-yielding corporate credit and quality businesses that can pay out good dividends. An appropriate blend of these assets should enable us to weather the current stormy times.