We find ourselves in a tough situation with high inflation and a Federal Reserve that is about to combat it with a series of interest rate increases. One risk to the current situation that could hurt the economy is stagflation.
Stagflation occurs when the economy experiences high inflation along with declining or stalling economic output. The declining economic growth then typically leads to higher unemployment. The last time the United States experienced stagflation was the during the oil embargo during the 1970s led by OPEC. The price of oil doubled, then quadrupled during this crisis.
Currently, the annual inflation rate increased to a 40-year high of 7.9% in February of 2022. Oil and gasoline prices have increased recently due to Russia invading Ukraine and worries about the supply impacts of that situation. Inflation is projected to average 7.5% for the remainder of the year according to Wells Fargo (WFC) Corporate and Investment Banking. Some experts are projecting that inflation may spike up close to 10% for March 2022 as a result of the increase in fuel prices.
The Federal Reserve’s Response
The Federal Reserve monitors the inflation rate and adjusts interest rates accordingly. The Fed is expected to raise rates by a quarter of a percentage point during its meeting on March 16, 2022. The Fed is about to begin a series of interest rate increases in an attempt to lower the inflation rate. The Fed has targeted an inflation rate of 2% in recent years. Inflation remained below 2% for multiple years after the 2008 financial crisis. While inflation did go slightly over 2% briefly before the pandemic, it did not go anywhere like the levels we are experiencing today.
If the effects of the Fed’s rate increase do not effectively lower the inflation rate, it is possible that consumer spending could slow down as people cut back on some discretionary items to afford essentials such as shelter, food, gas, and clothing. Consumer spending cut backs could lead to slower economic growth. That’s where the stagflation risk could lead to a recession.
If the Federal Reserve’s rate increases do drive down the inflation rate, it could lead to slower economic growth as lending for mortgages, business expansion, and other projects become less attractive. It may take a while for a series of rate increases to have an effect on inflation. It is possible that the Fed is too late to reverse inflation at this point. We’ll have to see how things work out.
The Federal Reserve needs a happy medium to simultaneously lower inflation and avoid a recession. That may be difficult to do. It is possible that the economy can still grow with inflation at these levels, but that remains to be seen. If the Fed increases rates too quickly and steeply, it could slow economic growth and lead to a recession. So, the Fed is facing quite a quandary.
Thoughts on the Potential for Stagflation
It may take a while for stagflation to materialize if it actually does. Consumers might be able to absorb the higher costs for now as unemployment is low and earnings have increased. If gasoline rises to $ 10 per gallon, then we would have some serious stagflation risks as consumers would likely cut down on other discretionary goods. The economy has the chance to make further gains for now in my opinion.
With that said, let’s look at some investing ideas for the current situation that we face.
Investing Strategies for Inflation and the Interest Rate Increase Cycle
If you are a strong believer in a dollar cost averaging buy and hold strategy, (ie 401k style investing) then stick with that. It takes the guesswork out as opposed to trading on emotions or trying to time the market and you’ll be buying shares at lower prices if the market is declining and benefit when the market increases.
However, if you want to position your portfolio for the current situation, here are some suggestions. If the Fed does increase rates quickly, interest on money markets will pay better than they are now. However, that interest will probably not keep up with inflation since the Fed is starting from almost nothing. The good news is that your money would be protected from a steep decline in the stock market.
You could purchase Treasury Inflation Protected Securities [TIPS]. TIPS are indexed to inflation, so the principal amount increases as inflation increases. The great feature of TIPS is that the original principal amount invested is protected. Thus, investors will never receive less than their original invested principle. TIPS also pay interest twice per year.
As for equities, your focus can be on companies that benefit from higher prices and high demand. Companies that essentially set the price of their product such as the input materials that comprise other products. These companies benefit from the higher costs associated with their products. For example, semiconductor manufacturers, oil producers, fertilizer companies, chemical companies, construction materials, and metals.
Here are some companies with increased earnings expectations for 2022 in these categories: Nvidia (NVDA), Oasis Petroleum (OAS), Mosaic (MOS), Livent (LTHM), Eagle Materials (EXP), Freeport McMoRan (FCX). Companies such as these can benefit from pricing power during inflation and during interest rate increase cycles. They are poised to perform well during this time.