What is stagflation?

Stagflation is bad for investors in stocks but good for buyers of commodities. It's an economic condition in which prices -- particularly that of oil -- and unemployment are rising and the Fed tries to cure the problem by keeping interest rates low -- leading to even higher prices as the value of the dollar declines.

This economic condition prevailed in the US during the 1970s. For example, in 1979, US core inflation, excluding oil and food, rose at a 9.4% annual rate, GDP grew at roughly 3%, and unemployment averaged 6%. Furthermore, this condition was bad for stocks which rose an anemic 0.37% annual average during the decade. According to The Economist, the 1970s stagflation resulted from two key sources:

• Loose money. The Fed kept interest rates low -- in effect printing money to offset the demand-crippling effect of oil shocks -- caused by the 1973/1974 Arab oil embargoes and 1979 oil supply disruption -- which led oil prices to increase at a 29% compound annual rate from $7 a barrel in early 1970 to $87 a barrel at the end of 1979 (prices adjusted for inflation). This led to a decline in the value of the dollar -- one measure of which is a 33% compound annual increase in the price of gold from roughly $35 per ounce in 1970 to a peak $850 per ounce in 1980 (in current dollars); and
• Weak productivity growth. In the 1970s, productivity growth fell sharply and unexpectedly from 3% during the 1950s and 1960s to less than 1%. Strong trade unions, little international competition and accommodating central bankers created a wage-price spiral in which rising prices led to higher wages which led to higher prices.

Are we on the verge of stagflation?

A comparison between the 1979 and 2006 suggests that we are not on the verge of stagflation. But it's not a completely clear cut case -- I think that weak unions and the threat of outsourcing make it unlikely that workers will have the bargaining power needed to spur a wage-price spiral. But I do expect commodity prices to keep rising.

Here is the balance of factors pro and con:

PROs

• Gold price up. The price of gold has risen at a 19.2% annual rate since January 2001 from $250 an ounce to $650 on Friday; and
• Oil price rise. The price of oil has risen at a 21.5% annual rate since January 2001 from $24 a barrel to $69 a barrel on Friday.
• Stock market fall. The S&P 500 has declined at a 1.1% annual rate since January 2001 from 1,342 to 1,267 on Friday.

CONs

• Unemployment tame. The unemployment rate of 4.7% is better than the 6% rate of 1979;
• Inflation not as bad. The April core inflation rate was 3.2% -- again tame compared to the 9.4% rate in 1979
• Productivity growth stronger. According to the Bureau of Labor Statistics, productivity grew 3.4% in the first quarter 2006 much better than the sub 1% level prevailing in the 1970s; and
• Labor bargaining power weaker. There have not been any significant strikes recently on the order of the ones that took place in the 1970s -- although there is a chance of one brewing at auto parts maker Delphi. Moreover with the rise of outsourcing, workers perceive a credible threat that their jobs could be sent to lower wage countries. This keeps a lid on demands for higher wages.

If we are not on the verge of stagflation, then what's next?

Just because stagflation does not appear imminent, it does not mean that the US economy is solid. I noted the sources of concern in my previous post. The essence of these details is that the US is borrowing -- both at the consumer and government levels -- to maintain its standard of living. While corporate executives (despite a recent slowdown in pay growth) and hedge fund managers are getting ahead, the average family is falling behind -- specifically, the median family income is 3.8% below its 1999 peak. 

The fundamental question is whether the US can maintain its position as the world's leading economy. I think China could surpass the US by 2015. By that year, China will lead the US and India. Here's how:

• China GDP: $21.3 trillion (assumes 10% annual growth on a 2005 base of $8.2 trillion)
• US GDP: $15.9 trillion (assumes 2.5% annual growth on a 2005 base of $12.4 trillion)
• India GDP: $7.8 trillion (assumes 12% annual growth on a 2005 base of $3.7 trillion)

What are the implications for investors?

I am most intrigued by the investment possibilities in India. As I noted in a recent TechTrends column, India has significant competitive advantages -- particularly in fields such as computer consulting. I recently interviewed the manager of a $400 million hedge fund which invests in Indian equities. In his view, the Indian stock market, while likely to be volatile, is at the beginning of a multi-decade bull market. 

Last week, the Sensex lost over 6% of its value, so I agree with the volatility part. But it might make sense to consider investment opportunities outside the US.

DISCLOSURE: I am neither long nor short shares of Infosys, EDS, Satyam, Wipro or Cognizant. For more about me, click here.