Bull/Bear Debate – Stagflation

Recent bull/bear debates following the 50 basis point cut in rates have stirred even further debates on inflation readings and the chances of a recession. Although the dialogue has been split between those who believe the cut will fend off a recession and those that believe inflation will spike as a result, we would like to add one more topic to the discussion; stagflation. The core debate that has arisen from the rate cut, but rarely discussed in the financial media outlets is the possibility of stagflation. Media pundits seem to avoid this talk like the black plague, but ideas gathered from our conversations in the industry emit the feeling of a real threat. Let’s take a look at some charts that contrarians might like to point out.

Stagflation is defined as a period of time where the economy experiences high inflation, stagnant growth and high unemployment. The dilemma arises when efforts to correct stagnant growth only worsen the inflation outlook. Essentially, using monetary policy the Federal Reserve can make two choices, each with a negative outcome. The last time we experienced a period of true stagflation was in the 1980s when commodity prices were soaring and growth was sub-trend. Another term we have seen floating around is “Agflation” which is inflation attributed to rising food prices; specifically agricultural goods. That puts pressure on producer and consumer inflation, lending support to the theory that stagflation could be in the future.
Let’s take a look at a few commodities and discuss their impact on the financial markets. First, Crude oil prices reached a nominal record high of $82.40 last week. Gasoline prices have held steady since the increase, but they are not likely to fall dramatically.
Gold has reached a 28 year high implying inflation concerns in the immediate future. Gold is typically referred to as a “inflation safe haven” as gold tends to increase as inflation worries persist. This is not a good sign for those looking for lower inflation.
Wheat prices have soared in the last few months. Although the market is currently overbought, this rally is being led by high demand and fewer supplies. Higher wheat prices will eventually be passed down to the consumer in the form of higher food prices. Are you seeing a trend yet?
Corn prices have come off of their recent highs, but are still holding above price levels not seen since 1996. The surge in 2006 was due to ethanol demand; however, prices may have a hard time coming down to a more reasonable level as corn is also used to feed livestock in one way, shape, or form.
Remember, the Consumer Price Index (CPI) that the Federal Reserve uses to gauge inflation? The Core CPI number is the Feds main measure of inflation; however, the data does not reflect the increase in agricultural (food) and energy prices as it is “ex-food and energy”. Will the Fed ever resort to using a better measure (either by coming up with their own, or including food and energy prices in their measure) or will we begin to trust the prices we see in our everyday lives at the grocery store and gas pump? Add in a weakening dollar and you can expect imported goods’ prices to increase, also adding to the overall inflation concern. Although the chart below shows decreasing inflation, the data is misleading and possibly unreliable to an extent.
To see more signs of stagflation, we have to begin to worry about both unemployment measures and economic growth. The unemployment rate is at a historically stable 4.6%; however, we recently saw nonfarm payrolls turn negative for the first time since the coming out of a recession in 2003.
Economic growth (measured by YOY GDP growth) continues to be modestly under 2%, but that could take a dip south with the looming housing recession having a broader impact on the economy. Whether stagnant growth will remain in our outlook remains to be determined. Let’s count on the economy bouncing back strong (as typically defines the U.S. economy); however, don’t be surprised to see a few more market pundits out there claiming of the possible stagflation scenario if economic growth stays below 1% for an extended period.
All of these factors taken into consideration and I don’t believe this market is one we want to chase. Witholding the stagflation cocerns, there are too many “if” factors still on the fence. Before extending this rally, the economy (GDP growth) needs to hold steady through this rough patch, agflation needs to be kept in check (highly unlikely) and we need to see some firming in the housing market. As we begin to enter the fourth quarter, the Christmas rally may be in jeopardy.

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