Stagflation threat overstated for stocks, bonds, report says

Globe and Mail Update

Stagflation might not be the bogeyman for stock and bond markets that it's cracked up to be, a top U.S. market strategist says.

Tobias Levkovich, chief equity strategist at Citigroup Global Markets Inc. in New York, has published a report looking at periods of stagflation - stagnant economic growth coupled with high inflation - over the past 40 years and analyzing returns experienced by various investment asset classes. He found that U.S. stocks and bonds were actually top performers during those periods, outpacing gold, oil, industrial commodities and residential real estate.

The data fly in the face of conventional wisdom, which holds that stagflation is a killer for both stocks, as a result of the lack of economic growth, and bonds, because of the high interest rates that result from inflation. They also suggest high-flying commodities such as gold and oil, which some investors have sought out as a shelter from a possible stagflation storm, might not be such solid bets after all.

"The idea that stock and bond markets may be poor performers during short bursts of so-called 'stagflation' may be more myth than fact, given historical study, while alleged investing in commodity-based protection seems equally unsound," he said.

Data suggest investors who bought high-flying commodities such as oil as a hedge against stagflation might not have made such a solid bet after all.

Mr. Levkovich noted that during the five generally recognized stagflation periods in the past 40 years (1970, 1974-75, 1980, 1982 and 1991), stocks and bonds actually had positive absolute returns in four of them.

On the other hand, gold prices have, on average, actually fallen slightly during stagflation periods, while oil prices have advanced less than 2 per cent - well behind the average gains of 6.2 per cent for the S&P 500 stock index and 6.7 per cent for the U.S. 10-year government bond total return index. Industrial commodities typically slump badly under stagflation: The Commodity Research Bureau's raw-industrials commodity index posted an average decline of 7.4 per cent.

Economists have been quick to point out that the current stagflation threat bears little resemblance to the deep economic malaise of the 1970s that gave the term prominence. In fact, many have qualified their stagflation references in recent weeks with phrases such as "mild stagflation," to differentiate current risks with the rampant inflation and high interest rate environment of the 1970s.

"The running parallels with the 1970s appear to be more thematic than quantitative, both in regards to inflation and economic growth," said Scotia Capital's Gorica Djeric in a report yesterday, who termed the current threat "stagflation lite."

But Mr. Levkovich argued that if the current short-term stagflation threat follows the script of the most recent U.S. stagflation episode in 1991 - the period that represents the best comparison, as both featured relatively mild economic downturn and inflation rates, high energy prices, a slumping housing market and financial institution troubles - then the outlook may be particularly bullish for equities and bearish for oil. In the 1991 stagflation period, the S&P 500 rose 12.4 per cent while oil prices slumped 26 per cent.

That history, combined with oil's massive outperformance of the S&P 500 this year, leaves oil "very vulnerable to a sharp pullback," he said.

"While the desire to continue buying commodities seems appealing, the run to date makes that option very costly."


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