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.
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.
Economists who focus on the money supply -- known as monetarists -- have an explanation for what happened in the 1970s. An expansion of the money supply can cause inflation just by itself, even if demand isn't strong enough to push up prices. When the supply of money is larger than the demand for money, monetarists argue, inflation is the result. "Inflation is always and everywhere a monetary phenomenon," argued Milton Friedman in "Monetary History of the United States," the book he co-authored with Anna Jacobson Schwartz.
The central banks don't get globalization
The arguments among the Keynesians, monetarists, neo-Keynesians, and neo-monetarists are by no means over, but it looks like stagflation, whatever your theory of inflation, could be set to ride again, thanks to a basic misunderstanding of the global economy by the world's central banks. You don't have to take my word for it this time. (See my June 23 column, "The worst-case scenario is not about us.") This time, it's the Bank for International Settlements that is raising the alarm.
The bank, an international organization of central banks based in Basel, Switzerland, argues that central banks from the Federal Reserve to the European Central Bank have misunderstood the effects of globalization on inflation. (You can read the bank's discussion here.) Globalization, the bank says, kept inflation low in the world's developed economies. Low-priced overseas goods replaced higher priced domestically produced goods, lowering prices. Competition with low-cost overseas producers forced domestic producers to lower prices, as well. That also acted to damp inflation.
Manufacturing overcapacity push prices lower
During this period, the prices of overseas goods weren't just lower than those produced by domestic competitors, they were also falling over time. Thanks to massive overcapacity in manufacturing centers, such as China and India, overseas producers were forced to compete with themselves and to repeatedly lower prices to keep the business of price-sensitive retailers, such as Wal-Mart Stores (WMT, news, msgs), in the developed economies.
Intervention in the currency markets by national governments kept the prices of overseas goods from rising as well. Most obviously, the refusal of the Chinese government to let the yuan freely rise in value to reflect China's huge trade surpluses kept the price of Chinese goods low and forced other overseas manufacturing nations to intervene in the currency markets, as well, in order to prevent their own goods from being priced out of the world market.
Low and falling global prices masked the effects of an expanding money supply in the developed world. Interest rates that fell as low as 0% in Japan and 1% in the United States provided a huge boost to the global money supply, especially as investment funds borrowed money at these rates to leverage their capital assets. The huge increase in the price of oil put massive numbers of U.S. dollars in the hands of oil producers, who then sought to recycle them by making investments in assets such as U.S. Treasury bonds and mortgage-backed securities, based on a booming U.S. real estate market.
Under other circumstances, an increase in money supply of these dimensions should have produced measurable global price inflation. But it didn't. Traditional measures of domestic inflation in the developed economies didn't show rising prices. With inflation measures showing inflation still contained, the Bank for International Settlements argues, the world's central banks kept the money supply spigots wide open for longer than they should have. That has built up considerable inflationary pressure around the world.
Bidding for workers in China
And now that global inflationary pressure is in the process of being turned into actual, measurable inflation because prices for goods produced by overseas manufacturers in China, India and elsewhere have stopped falling.
In China, for example, some regional manufacturing centers have developed labor shortages. Chinese companies are paying larger bonuses to attract workers from outside their own areas or relocating work to areas with still-abundant cheap -- on China's wage scale -- labor. Rising raw materials costs have cut into profit margins again and again until a significant portion of companies in such sectors as steel and chemicals are not profitable. Thanks to the willingness of Chinese banks, despite government policy, to lend more money to unprofitable companies, these money-losing enterprises aren't going out of business. But they are certainly no longer able to significantly lower their prices. For foreign customers, the small increases in the value of the yuan against the dollar also make Chinese goods more expensive.
These changes -- in Chinese wages and in the yuan-dollar exchange rate -- may seem very small. Indeed they are. But as the Bank for International Settlements points out, it's not necessary for prices of Chinese goods to rise significantly in order to increase the measured rate of inflation in the developed economies that are big consumers of offshore goods. If prices simply stop going down, that alone is enough to push measured inflation significantly higher in the future.
Higher rates ahead?
If the Bank for International Settlements is right, the global economy has built up significant inflationary momentum because global central banks, which did not see inflation in their usual measures, kept the money supply growing too fast for too long. That has created exactly the kind of inflationary situation described by monetarists in which too much money supply faces too little demand for money.
At the same time, because significant global inflationary pressures are just now starting to show themselves -- and because managing prices for Chinese and Indian goods by raising U.S. and European interest rates in order to damp U.S. and European consumer demand is likely to take a while -- inflation rates are likely to rise to higher levels than central banks in developed economies find comfortable.
So, according to the Bank for International Settlements, we could be headed for slow growth and high inflation for a while -- even if everything goes well in the effort to slow inflation by raising interest rates.
Stagflation isn't a certainty. But for the first time I can see a plausible scenario that gets us to that very uncomfortable position.
New developments on past columns
When this market bounces, sell: The stock market rallied strongly on Thursday, June 29, after the Federal Reserve raised short-term interest rates another quarter of a percentage point and indicated that it sees more likelihood that the economy is slowing. Investors who had bid the odds of another quarter-point rate increase at the Federal Reserve's Aug. 8 meeting up to 90% before the meeting rushed to buy stocks after concluding from the Federal Reserve's June 29 press release that an August increase was now less likely. The Dow Jones Industrial Average ($INDU) closed up 217 points, or 2% for the day. The optimism hung on a relatively minor change in the Fed's press release: Instead of saying, as it did in May, that the Fed's Open Market Committee "sees growth as likely to moderate to a more sustainable pace," on June 29 the Fed said "indicators suggest that economic growth is moderating." I think the June 29 move in stocks continues the bounce that began on June 13, and it could well run for the first half of July as investors react with relief to the chance that the Fed won't raise interest rates in August. But it is still likely that when investors start to worry about an August rate increase again, this bounce will peter out with a July retest of the May high on the Dow industrials at 11,642, about 4% above the close for the June 29 post-Fed-meeting move. I'd still treat this bounce as an opportunity to sell selectively and position your portfolio for buying at an August or September low.
3 picks for the dog days of summer: Now that it has paid off the money that it borrowed from the government during Japan's banking crisis in the 1990s, Mitsubishi UFJ Financial Group (MTU, news, msgs) wants a bigger piece of the global banking pie. The company, the world's biggest bank by assets, has opened negotiations with the U.S. Federal Reserve about obtaining financial holding company status in the United States. That would allow Mitsubishi Financial to expand into the U.S. insurance, underwriting and investment-banking markets. The company already has 13 bank offices in the United States and owns 62% of UnionBanCal (UB, news, msgs), the 21st largest bank in the United States. But without holding company status, Mitsubishi Financial can't consolidate its operations with UnionBanCal, acquire other U.S. financial holding companies or compete in the lucrative insurance and investment banking sectors. Right now, more than 80% of Mitsubishi Financial's profits come from its home market in Japan.
3 ways to invest in Europe's revival: On June 19, Nestle (NSRGY, news, msgs) purchased weight-management company Jenny Craig from a group of private investors. Jenny Craig sells branded weight-management foods and runs weight-management classes in the United States, Canada, Australia and New Zealand. Sales for the last 12 months were more than $400 million, and Jenny Craig showed double-digit organic revenue growth. Nestle paid approximately $600 million for Jenny Craig. The acquired business will help Nestle's Nutrition group expand its presence in the United States, the world's largest nutrition and weight-management market.
Editor's Note: A new Jubak's Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Mitsubishi UFJ Financial Group. He does not own short positions in any stock mentioned in this column.