Stagflation: The Two-Headed Monster by Josh Sidman


by Josh Sidman
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Josh’s Blog Post

Oct. 18, 2007

Stagflation: The Two-Headed Monster

In previous articles (“Big Ben & The Shit-Cloud” and “The Perfect Storm”), I discussed the possibility that the American economy may be headed for a rare and highly problematic situation in which we experience economic stagnation and erosion of the currency at the same time. In ordinary times, economic crises usually take one of two forms – i.e. either recession or inflation. Since these two phenomena normally spring from opposite causes, they rarely occur concurrently. However, if an extended period of bad economic decision-making is combined with unfavorable world conditions, it is possible to have both at the same time. This extremely destructive phenomenon is called stagflation. The unique challenge posed by this economic two-headed-monster is due to the fact that the cure for either of the two problems is likely to exacerbate the other, and vice versa.

Recent headlines seem to indicate that stagflation is increasingly likely. A Reuters news story today entitled “Housing Starts Skid, Inflation Flares” highlights the developing conundrum facing the financial authorities. Housing starts last month fell 10.2% to an annualized rate of 1.191 million. (A level of 1 million is consistent with past recessions.) Meanwhile, spiking prices in commodities and an accelerating increase in the Consumer Price Index indicate that inflation is a growing concern. The threat of inflation couldn’t come at a worse time from the point of view of the Fed, since just when it would like to have a free hand to cut interest rates further in order to bail out the real estate market, rising prices and the eroding dollar may severely limit the extent to which monetary policy can be used to address the threat of recession.

So, what does all of this mean for the average Joe? How should one manage personal finances in such a tricky environment? Unfortunately, there are no easy answers, since in a period of stagflation virtually every form of wealth is vulnerable. Investing in the stock market (which is still near record-high levels) while the economy may be on the brink of recession is obviously not a good idea. On the other hand, conservative investments like bonds and other fixed-income instruments are problematic due to the falling value of the currency.

While I do not profess to be an expert on the subject of investing, I would like to offer three investment ideas that I think will outperform if stagflation becomes a reality. The first is one that I have discussed before – i.e. gold. Gold has historically been considered one of the safest stores of economic value. The one drawback of gold is that it doesn’t yield any return (like a bond or dividend paying stock). However, at a time when bond yields are low and stocks look vulnerable, this aspect of gold is less problematic. Gold has increased dramatically over the past couple years, and while I am usually wary of investing in anything that has already gone up a lot, in this case I think gold has a lot further to go. Since the Fed seems to be taking the “easy” approach to our current difficulties (i.e. loosening monetary policy), the recent trend of weakness in the dollar is likely to continue. Since for most of the last century, people all over the world have used the dollar as the primary store of value, once people start questioning the wisdom of continuing to do so (a trend that is already underway), an enormous amount of wealth will start to exit the dollar and look for alternative stores of value.

Given that other countries are likely to follow the Fed’s lead in terms of monetary policy (since allowing their currencies to appreciate excessively versus the dollar hurts their abilities to export their products to the US), there is no guarantee that simply switching out of dollars into other world currencies will be a successful strategy for preserving wealth. If there is a “race to the bottom” in terms of central bank policies, currencies could lose value across the board. It is for this reason that I believe gold still represents a huge opportunity. The amount of gold that exists in the entire world is tiny in comparison to the amount of wealth that could soon be looking for a safe haven, so I think it is not unlikely that the price of gold could double or triple from its already high levels.

Another investing strategy that is based on similar reasoning would be to invest in the Japanese yen. The dollar has already slid significantly against many world currencies (most notably the Euro and the Canadian Dollar), but it has so far held its value against the yen. One factor that I believe is likely to lead to a significant depreciation of the dollar versus the yen is what is called the “carry trade”. In response to Japan’s decade-long recession during the 90s, the Japanese central bank cut short-term interest rates to near-zero. This created a hugely profitable opportunity for investors to borrow yen and convert them into dollars, where they could then invest the money at a higher rate of interest. The enormous amount of money that was put into the carry trade represents a tide that at some point is likely to start flowing in the opposite direction. Once interest rates in Japan are no longer low relative to rates in the US, and once the value of the dollar starts to erode vis-à-vis the yen, all of the money that was put into the carry trade over the years is likely to be unwound.

When I was employed as a derivatives trader in Tokyo in the mid-90s, I used to exchange my yen-denominated salary for dollars at rates as low as 80 yen per dollar. I see no reason why we might not see the yen trading at 100 to the dollar in the medium-term. I also see little reason to fear that the dollar might appreciate significantly vis-à-vis the yen. I therefore believe that buying yen represents a very good risk vs. reward scenario at this point.

Lastly, for those who want to get a bit more aggressive in their investing, I would suggest selling US bank stocks short. The recent troubles in the sub-prime mortgage market highlighted the extent to which US banks are vulnerable to declines in real estate values. Yet, to date, bank stocks by and large haven’t fallen very much. It is my opinion that the bear market in real estate is just beginning and that property values have a lot further to fall (an opinion that is increasingly echoed even by the “official authorities”, who are occupationally obligated to be unrealistically optimistic). When this happens, I think the extent of bad-debt exposure of the large banks is likely to prove to be very large. I wouldn’t be surprised if we saw a large bank or two go bankrupt or be forced into merger or restructuring.

The problem with any prospective short-sale is that timing is everything. You can be exactly right in your analysis but just be too early and end up getting wiped out before the stock falls. For example, if the Fed moves to aggressively cut rates again, the stock market in general, and financial stocks in particular, would likely rally, and a short-seller would lose money. That being said, I don’t think there is a large amount of risk on the upside in these stocks, so if this trade is implemented in such a way that it represents a small percentage of one’s overall portfolio, I think it will prove to be a good countermeasure if the dreaded stagflation rears its ugly heads.

Big Ben & The Shit-Cloud by Josh

American Economy: The Perfect Storm by Josh Sidman

2 thoughts on “Stagflation: The Two-Headed Monster by Josh Sidman

  1. Josh,
    I found your post on Stagflation to be reassuring but also a bit eerie as your 3 main themes are precisely how i’m investing my money. The gold and yen ideas are pretty well accepted by most as good stagflation hedges, but i have to give you kudos on shorting banks. Not too many people have clued into that yet. For your readers benefit, a really easy way to short the banks is to buy Proshares SKF (that’s how i’m doing it my retirement accounts.)

    You’re dead on that Stagflation is not a common occurrence. In fact, it requires a heavy dose of government malfeasance to pull it off. I explain how it has worked in the past on my own site if you or your readers have any desire to check it out.

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