Stagflation: A new peril for stocks

By Jim Jubak

Great. Something more for investors to worry about.

There are inflation worries, of course. The financial markets are worried that inflation is running so hot that the world's central banks will raise interest rates again and again and again to fight it. That wouldn't be good for either stock or bond prices.

There are slow-growth worries, of course. The concern here is that the central banks will overshoot and raise interest rates so high in their battle with inflation that they'll either slow or stop economic growth. That certainly wouldn't be good for stocks and if growth slowed enough, rising bad debt could take a bite out of some sectors of the bond market.

And now there are stagflation worries to add to the list.

Concerns that we could see a rerun of stagflation, that dreadful mix of slow-to-no growth and high inflation that made a good part of the 1970s such a bad time for investors, have been on the rise this year. But until recently, I hadn't seen a convincing explanation for why this monster should rear its ugly head now. However, the Bank for International Settlements, based in Basel, Switzerland, the bank for the world's central banks, warns in its most recent annual report that global stagflation is a real possibility. I find the bank's logic convincing, and I think investors need to factor the possibility of stagflation into their thinking.

Why you should be thinking about stagflation

Most of the time, we associate high inflation with periods of fast economic growth, based on Keynesian economic theory, named after the great English economist John Maynard Keynes. (Keynes is, to the best of my knowledge, the only great economist who was also a masterful investor: He managed the Kings College, Cambridge, portfolio to an average annual return of 13.2% from 1928-1945.)

According to Keynes, fast growth in demand leads to bottlenecks that prevent supply from keeping up with demand. That leads to rising prices for goods and services. At some point an inflationary psychology sets in -- the price-wage spiral -- as higher prices cause workers to demand higher wages to keep up, which in turn produces higher prices.

This is exactly the kind of inflation that the Federal Reserve seems determined to fight with its current set of interest-rate increases. Higher interest rates should, the theory goes, depress growth in demand, which should lead to lower prices.

But as the 1970s proved, this theory of inflation with its focus on supply and demand doesn't explain all instances of inflation. According to Keynesian economics, it should be impossible to produce inflation during a period of slow growth and high unemployment. Slow growth and high unemployment should depress demand, leading to lower prices.

The 70s: A rotten time for investors

However, in the 1970s, despite Keynesian theory, the economy went into a nose dive and inflation soared. Real GDP actually fell in the United States from 1973 through 1975. From 1973 through 1977, real GDP grew at an annual compounded rate of just 1.3% a year. But from 1973 through 1979, inflation averaged an annual 8.8% a year.

As you'd imagine, this wasn't a great period for the stock market. According to Ibbotson Associates, the S&P 500 ($INX) showed an average compounded rate of return of just 3.2% from 1973-1979. Long-term government bonds didn't do a whole lot better, with a 3.5% compounded annual return for the same period.

Mind you, those were the nominal rates of return for the period, i.e., before inflation. Figure in inflation and investors lost money during these years.

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