Stagflation could be a future scenario. The Federal Reserve and the government are printing limitless amounts of dollars to inject into the economy, and while this happens, the supply of goods and services is decreasing due to deglobalization.
Unemployment, inflation, and recession are realities not far from becoming ours, the first one has already started to grow exponentially.
But as frightening as this might sound, we can prepare and learn how to invest so we can continue to build wealth regardless of the circumstances.
In this article, I will compare today’s inflation with the 1970’s case, analyze the unemployment rate in the months to come and look at the misery index.
After this overview, I'll share with you what investment strategies I’m considering during this period of time and why.
The last time we had stagflation was back in 1970. So we’ll proceed to analyze a chart that dates back to 1960 because it’s important to have the context.
This chart has the inflation percentage on the left and it starts off in 1960 when inflation was very low.
Around 1970 inflation starts to go up and back again in the early ’70s, but then it shoots back up to a peak in 1980 at almost 15%.
15% is what the government is willing to admit to, so inflation was most likely much higher.
After its peak, Volcker comes in and destroys inflation by jacking interest rates almost up to 20%, and so inflation comes crashing down in 1985, and it bottoms out temporarily at 5% right when we had The Plaza Accord.
During this time, the dollar and the international markets, especially relative to the Yen and the Deutsche Mark, went down by 50% but domestic inflation was only around 5 or 6%.
Inflation went up again slightly in 1990, came down, and went up a little bit before the dot-com bust. After this, it peaked up in 2007 to come crashing down to a little less than zero.
Although we had massive asset deflation in 2007 because they came crashing down by more than 50%, the Consumer Price Index (CPI) barely got down below zero.
Inflation went up again in 2010, and right back down in 2015 and it leveled off to where we are today, supposedly, based on the government numbers.
From 2008 to 2012, home prices, which are people’s main asset, went down in value and steadily bottomed out in 2012 while at the same time, the CPI of the goods and services you buy on a daily basis, went up.
I say this because it’s important for us to understand that asset prices go down while the cost of goods and services goes up.
Now, having the context of inflation for the last 60 years, we need to comprehend how this is important to what’s going on today.
Here’s the big picture.
The Fed and the government, as I said before are printing money like there’s no tomorrow, spending it into the economy and creating deposits most likely through MMT, which means they’re not just extra reserves held at the Fed for the primary dealers.
The government, on the other hand, is, of course, monetizing the debt because the Fed is buying it almost immediately to keep interest rates low.
Now, let’s imagine for a moment the United States consists of 5 people, one coffee shop, a store, the Fed, and the government.
Between the Fed and the government, they created six dollars of additional money that goes into the pockets of the people, but, they don’t have as many options for food, because the coffee shop is closed due to Covid-19.
So the only option they have to spend the dollars they received from MMT, is the store.
What would happen if the supply of goods and services decreases, and the amount of money increases?
Unfortunately, for the U.S. it gets worse than price inflation because we now have supply chain disruptions, and in my opinion, we’ll have a massive push towards deglobalization.
Here’s how it works.
We have a low wage country called X, which is currently importing goods and services to the United States in exchange for dollars.
This means the United States imports are things, and their exports are green pieces of paper called dollars.
So for example, if country X is importing fewer medical masks, pharmaceuticals, or whatever, and the U.S. starts to create them locally, prices will go up because we don’t have low wage workers, we have high wage workers.
Additionally, this means we would have more dollars staying and circulating in the United States than before when we were exporting dollars.
If we had, for example, an additional six dollars in the system, two or three dollars used to leave the country and go to the low wage country, which means only three dollars were circulating in the U.S.
However, today we can face a scenario where all six of them are circulating in the United States creating more domestic consumer price inflation due to not exporting dollars, having a higher supply of money because of MMT and, a lower supply of goods and services.
Yet, you may think, because people aren’t getting loans due to the situation, the number of dollars circulating will decrease, and that’s correct.
Still, the banks keep on creating loans to buy.
Why? So people can purchase a car or a house.
This means there would be fewer dollars created, but fewer dollar created or the money supply is contracting for homes and cars, not necessarily food you buy daily.
We have a scenario where the prices of things we buy on a daily basis will go up, while cars and houses will go down.
In conclusion, I think it’s very likely over the next year or two we could see inflation above 6, 10 or even 15%.
To understand what’s happening in terms of unemployment, I’ll explain a chart of the unemployment rate dating back to 1970 and going up to today.
On the left hand, we have the unemployment rate from zero to 12%, and it starts in 1970 with an inflation rate of 5 or 6%, approximately.
As you can see it goes up, then back down, and after this, it reaches a peak in 1980 at a 12% rate, after this, it went down again and remained steady from1985 until 1990.
It stayed persistent for a little bit but then reached three more peaks, 8% when went through a mild recession in 1990, 7% near the dot-com bust in 2005, and 12% around 2008.
After this, it went down to where we were, almost 30 days ago, when unemployment was at an all-time low.
Of course, after Covid-19 things have changed, and many analysts think unemployment is going through the roof, even to 30%, if not higher.
If we look at last week’s jobless claims at 3.3 million it’s not hard to understand why are they thinking we can go up to those numbers.
Think about this scenario.
If we have inflation over 10%, which I think is very realistic on the goods and services people buy on a daily basis, and unemployment at 30%, where does this put us on the misery index?
Far higher than it was in the 1940s during Wolrd War II when we had the interset rate peg they’re suggesting we do now, higher than 1970s, and far worse than how it was in the 1930s during the Great Depression.
Look at the charts.
Nevertheless, we can think about what are the potential solutions to this.
Today, many people, especially those at risk are being quarantined, but for this example’s sake, and to find solutions, let’s say we quarantine everyone over the age of 55.
Analyze this chart.
If this measure is taken, around 65 million people would stop working, not to mention these people are the ones with money to spend. Young people don’t have money to spend.
So if one man’s spending is another man’s income, unemployment will skyrocket, especially because the United States economy is 70% consumption.
So, since we can all agree on this, no matter how optimistic you’re about the Covid-19, if 60 million people are quarantined, unemployment will go through the roof.
This will take the rate at least as high as the 1970s.
On the other hand, services are a huge part of the American economy, so what will happen when all the restaurants close?
The headlines I’ve read recently affirm 10 out of 30 restaurants can go out of business permanently due to this quarantine.
Also, most people understand we won’t get rid of the Covid-19 until we get to herd immunity, we can only get there by having a vaccine or by letting 60 to 80% of the population gets infected to build up the immunity and keep it from spreading.
This will also affect domestic and international travel.
We’ve seen a huge outbreak in New York, so if this gets very serious, and there’s another state that doesn’t have many cases, but doesn’t want to disrupt their economy either, do you think they’re going to allow flights from New York?
We can take as example countries like Singapore and South Corea which have handled this very well by tackling it strongly from the beginning.
However, after the infection flatlined, they opened up again for flights and the infection rate started to go back up because people are spreading it when they come back in on an airplane.
This Covid-19 crisis is too complicated to fix quickly
So if services are hit very hard and travel is restricted on a moving forward basis until we get a vaccine in a year or 18 months, unemployment will increase substantially.
There are three optimistic projections of our current situation.
I’ve tried to simplify them for you, and have done the math, but if anyone thinks there’s a different option other than what I’ve outlined, they haven’t done the math.
1. Overweight the economy
Let the Covid-19 rip through the population as fast as we can to build up herd immunity.
With this option, we will be doing as little damage to the economy as possible, meaning the economy would be overweighting.
I think there would still be significant damage done, there’s no way of getting around it, but we’ll be sacrificing the general population’s health.
If we are optimistic, and we only need to achieve 60% of the herd immunity, it will mean 198 million Americans need to be infected, and with a fatality case of 1%, again, being optimistic, this means 1.9 million Americans would die.
I don’t think this is a very good option.
2. Overweight the population’s health
We’re still going to have people die, but the economy will suffer tremendously. This means a total lockdown as they had in China, which will enable us to save a lot of lives but from an economic standpoint, we would go into 1930s style depression, but far worse.
If we go through a 1930s depression it doesn’t mean we’ll go through a deflationary depression, we can go into an inflationary one, which I think is most probable.
3. Implement a balancing act by not sacrificing the economy totally neither the population’s health
Even in this scenario, we would have a lot of fatalities and the unemployment rate getting near the 1970s rate if not higher.
In my opinion, if we want to have similar results as China, Japan, or South Korea, we need to be proactive.
We can’t expect to have good results without taking any actions, the math doesn’t work.
If we want Japan’s results we need everyone wearing an n-95 mask, if we want China’s outcome, we’d have to go into total lockdown, as they did, and if we were to emulate South Corea, we have to test 100% of the population.
In terms of economy, Japan took a huge hit. Look at the chart of the Japanese PMI which includes the manufacturing index and services.
As you can see, it drops off a cliff, and the same thing happened with China, just take a look.
This shows us that just because you’re able to keep you’re economy going while at the same time getting the R0 of the Covid-19 as low as possible, it doesn’t mean it won’t still crush the economy.
We can see the most likely outcome for the U.S. We have to try and keep the virus under control so we don't over-run the hospital system. But in doing so, we have no other choice than to damage the economy. There are no easy compromises.
Unemployment will be extremely, extremely high
Nevertheless, we can look for opportunities to invest and stay safe during this time.
Stagflation investing: my personal considerations and strategies during this time
This isn’t investment advice, it’s just what I’m considering for my own portfolio.
It begins with a process of elimination, where I figured out what I don’t want to buy.
First, let’s analyze a chart that dates back to 1995 and all the way to 2020.
The red line indicates growth stocks, and the blue line represents value stocks, this is relative to the S&P500.
If the line is going up it’s outperforming and if it’s going down is underperforming.
From 2005 to about 30 days ago, approximately, growth did very well and value did extremely poorly.
On a moving forward basis, if I believe the economy is going to struggle I don’t want to own anything expensive, so we can take growth out of the list of investing.
To be clear, I don’t like value either because I think the entire S&P500 is overvalued when we look at metrics like the market cap to GDP or the cape ratio.
The next possible investment option is long bonds, but please, I don’t want anything to do with 10-year or 30-year treasuries.
It’s not because interest rates will go down and the prices won’t go up, but if we have a lot of inflation potential, and the market perceives inflation coming down the pipeline there’s going to be a lot of upward pressure on the yields on the long end of the curve.
Also, The Fed could still take rates down to negative 50 basis points, or even 100 basis points.
But, just because they’re taking interest rates lower it doesn’t mean the interest rates on the long end of the curve will come down.
We could see them steepen, and yes! The Fed could come in and try to peg the yield curve by printing more money, but when the peg breaks or its lifted, interest rates will shoot higher.
This means you’ll lose value in the form of purchasing power when getting paid back in dollars or you’re losing purchasing power in the form of the value of the bond you own and is currently going down.
Yet, I see many investment opportunities, but before I explain them, I want to point out to Chris Macintosh's words, a former fund manager, and a Wall Street insider who I interviewed and talk with about this situation.
“How are we positioning it? Largely it’s hard assets and it’s value overgrowth.
What I mean by value overgrowth is, when we come out of this chaos, that’s when balance sheets and solvency are going to matter, we’re going to be in an environment with many wreckages because of the impact that’s going to, and is currently taking place in the economy right now by shutting down businesses.
I don’t think people fully understand how dramatic that’s going to be. 60% of the local New Zealand SMEs have 27 days they could last with no income, and we’re currently on lockdown for four weeks.
Now, to cut to a certain extent, New Zealand doesn’t matter, but this is taking place across Europe, and the United States, among others, but people are still focused on the here and now.
Think about what it’ll look like in four or six weeks, even six months. People are calling for a V-shaped recovery, but I’m not sure they’re looking at the numbers. The one thing I’m 100% sure is this won’t be a V-shaped recovery.
Also, this means a massive contraction of productivity and the supply of goods.
Ironically, if we go back to all the stuff we’ve been looking at for the last few years, which have been these decimated sectors whereby there’s no capital or little capital investments into them, have extremely cheap valuations, and now they didn’t just go cheaper, they’re critical to society”.
So we like real assets, the basics ones like food, energy, and shelter. Please notice I wrote shelter, I didn’t write real estate.
Because right now I’m seeing them as two completely separate asset classes.
A shelter would just the basics you need to survive, meaning a roof over your head.
Anything in addition to that, a huge backyard of five acres, a five thousand square foot house in a super fancy neighborhood or a penthouse loft in New York worth five million dollars is in excess of just basic shelter.
So I’m bearish on real estate, yet, on shelter, not necessarily bullish, but I don’t think we’re going to lose money on this asset class if we go into an environment of a poor economy with stagflation.
I also like the asymmetry in Bitcoin, but in my opinion, Bitcoin is not digital gold or insurance. However, it could be a very interesting speculation.
Make sure you watch it because we discuss an ETF which is in one of the industries I mentioned before, where the underlying assets have very little debt and it pays a 13% dividend yield!
For more content like this that will help you build wealth and thrive in a world of out of control central banks, take a look at my blog!