Investing for stagflation

By Andrew Allentuck
Globeinvestor Magazine Online,
June 26, 2008

Stagflation is making investing tougher than ever. The combination of stagnant economic growth and rising prices has bond investors wondering if the 1970s are making a comeback.

Conventional bonds don’t do well in times of stagflation. Fixed coupons become less appealing as interest rates rise, reducing the appeal of existing bonds. For stocks, slowing economic growth is hard on earnings and therefore tends to reduce share prices.

This time it doesn’t look quite like the stagflation of 30 years ago when interest rates headed into the low 20-per-cent range and soaring consumer prices prompted Ottawa to form the Food Prices Review Board.

Today, with the consumer price index and interest rates in the low single digits but likely to rise, it looks like stagflation light, but the issue for investors is much the same.

Aron Gampel, Bank of Nova Scotia’s deputy chief economist, see similarities between now and then. “Back in the 1970s, it was the ascent of oil prices engineered by the Organization of Petroleum Exporting Countries that sent a barrel of oil to $50. Energy prices filtered through to food and sent consumer prices into double-digit gains. Today, energy prices are soaring and economic growth is slowing. The comparison is apparent.”

Energy prices are the heart of the problem. In spite of a good deal of purring by the masters of OPEC that they will try to increase shipments and bring down the prices and gas and oil, oil prices continue to rise. The price of a barrel of oil, $58 (U.S.) in 2006, has recently been quoted at $138. That puts today’s oil at nearly 240 per cent of the price just 24 months ago.

High energy prices slow economic growth. The mechanism is simple: Money spent to put gas in your car’s tank cannot be spent on shopping for other things. As a result, Canada’s gross domestic product is expected to rise just 1.3 per cent in 2008 compared to 2.7 per cent a year earlier. In the United States GDP is also expected to rise 1.3 per cent, down from a 2.2-per-cent growth rate in 2007 – according to Scotiabank’s economics department.

However, Patricia Croft, chief economist for Phillips Hager & North Investment Management Ltd. in Vancouver, sees key differences between the economies of the 1970s and today.

“First, central bank policies are different this time. They plan to resist inflation. Second, in the 1970s, workers, who had appreciably stronger unions than today, were able to pass through their costs of living in the form of wage increases. That set off a wage and price spiral. This time it’s different, central banks will fight inflation and accept some stagnation. And the unions now have much less power.”

For investors, stagflation presents what could be the worst of all possible worlds.

If conventional bonds will suffer from rising interest rates and stocks will suffer from slow economic growth, where should money be invested? Here are a few modest proposals.

Buy gold as an inflation hedge and as a store of value, suggests Edward Jong, portfolio manager of the FrontierAlt Opportunistic Bond Fund.

Sell short stocks that are heavily energy-dependent or those that suffer compressed margins, Mr. Jong adds. It’s an obvious play on airline stocks that are nosediving and even on retailers that will be able to sell less to consumers who have been tapped out filling their cars’ gas tanks.

Stick with cash, short-term guaranteed investment certificates and very short-term debt instruments like treasury bills that can be rolled over to benefit from the upward trend of interest rates. Already the European central bank and the Fed have indicated that they have biases toward higher rates, Ms. Croft says.

Buy Government of Canada real return bonds that rise in payouts and value as the consumer price index goes up. Because insurance companies use them to maintain the future value of the life insurance benefits and annuities they must pay, RRBs tend to be expensive in relation to conventional bonds of similar maturity date, Ms. Croft explains. In the United States, Treasury Inflation Protected Securities also produce rising payouts and price gains as the consumer price index goes up. These instruments are traded and sold by investment dealers.

Buy commodities like energy futures and commodity indexes that, as the measure of inflation, ought to thrive. The problem is that commodities have had a four-year run and no trend is forever, Mr. Gampel explains.

If agriculture is the new gold, crops, farm machinery and fertilizer are the place to be, he says. Agribusiness stocks should be immune from the downdraft created by stagnation, Mr. Gampel adds.

Buy infrastructure stocks or other investments. They are often regulated by government and therefore have assured returns, often tied to the rate of inflation, Mr. Gampel suggests. They are immune to many risks of private sector companies, for they usually are monopolies like airports and highways.

Invest in real estate. Though hard to sell in fractions and often lumpy in returns, it has been a good store of value over cycles of as much as 40 years, Mr. Gampel says.

Special to The Globe and Mail