Worst Investments for Stagflation

My macroeconomic forecast for the next 3 to 5 years which I unveiled in my last blog is for stagflation. This week's blog will be about which investments are the worst for stagflation. As for myself, I don’t tie my whole portfolio to my macroeconomic forecast. I could be wrong, so I tilt some of my portfolio to stagflation investments (10 to 20%) and the rest elsewhere. It helps to hedge so that, if my forecast is wrong, I am not forced to sell assets that have lost value. Today a lot of people are finding themselves in the unfortunate position of needing to sell their houses to raise cash to pay debt and living expenses. You never want to be forced to sell an asset that has lost value. A well-diversified portfolio is key - you never put all your eggs in one basket.

I will review all of my investments against my economic forecast to determine whether any are no-nos for the forecasted economic environment. For example, for stagflation medium and long duration bonds funds are not good investments. If I have investments that are medium or long term bond funds I will decrease or eliminate my investment in that fund.

Also, always understand the tax consequences of your investments, how the investment works and what your exit strategy will be.

Worst investments for stagflation:

Long or medium duration bonds (see blog Bonds - February 27, 2010). For example, if you are invested in Vanguard Long-Term Investment Grade Bond fund (VWESX) with the average duration of 12.1 years and interest rate increases by 2%, your investment will decrease by 24.2%. If you invested $100,000 in the fund, after the 2% increase in interest rate, your investment value would $75,800. The time to invest in long term duration bond funds is when inflation and interest rates are at their highest and will be decreasing in the future. That’s why long term bonds have been very good investments over the last 3 years with declining interest rates. Over the last 3 years Barclays Capital US Aggregate Bond Index has returned 6.14% and the S&P 500 Index has returned -4.17%. This is why you do not want to follow performance. With the economic environment changing to higher interest rates and inflation you would not want to be invested in long or medium duration bond funds.

Long term fixed rate annuities, Guaranteed Investment Contracts (GIC) or anything that pays a fixed income. GICs are like Certificates of Deposit (CDs) but they are not guaranteed by the Feds and FDIC; they are only guaranteed by the company that issues them to pay the fixed interest rate. Today you can buy a GIC that will pay you 3.0% annually for 5 years. That 3% income is locked in for 5 years. If the inflation rate is 7% you lose 4% on you investment every year. GICs work like every other type of fixed income investment that will not protect you against rising inflation. The time to buy long term fixed income investments is when inflation rates are declining.

Investments in cash, for example, CDs, savings accounts, etc. Cash, or cash equivalents, generally provide the worst protection against inflation since it will not keep up with inflation. If inflation is 9% and you are getting paid a 2% interest rate annually for your saving account in 10 years (rule of 72) you would lose almost 50% of the value of your investment to inflation. During periods of inflation you just want only enough cash for emergencies. This might be 6 months of your living expenses. You may want to do CD laddering to get the best return for your emergency cash fund.

Stocks. In the short to medium term stocks have an inverse relationship to the Consumer Price Index (CPI). You will need to be very selective on the stocks that you invest in. Pricing power is very important when you have stagflation. Companies that cannot raise prices faster than their input costs will not do well in this environment. If you are a paint manufacturer and cannot raise your prices for paint faster than your major input oil you are going to experience a decrease in profitability or lose money. This will drive down the stock price. Companies that produce durable goods do not do well in a stagflation environment. (Durable goods are products that are not purchased frequently, for example appliances, home and office furnishings, and jewelry.) Examples of companies which are unlikely to prosper in a stagflation environment:

Whirlpool (WHR)

Boeing (BA)

Tiffany (TIF)

In next week’s blog I will be talking about the best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.

© 2010 Paul Cusick

Paul