Weekend Reading: The Return Of Stagflation

One of the worst possible outcomes for the U.S. economy, and ultimately for investors, is stagflation. Of course, if you weren’t around in the 60-70’s, there is a reasonably high probability you are not even sure what “stagflation” is. Here is the technical definition:

“stagflation – persistent high inflation combined with high unemployment and stagnant demand in a country’s economy.”

How can that happen? Exactly in the way you are witnessing now.

While the current Administration is keen on equalizing trade through tariffs, trade deals, and trade deficit reduction, they have also embarked on a deficit expanding spending spree which has deleterious long-term effects on economic growth. At the same time, the administration is attacking our major trading partners, particularly China, leading to a push to shift away from the U.S. dollar as a reserve currency.

What does all that mean?

Here is the problem with the current trajectory.

A weaker dollar leads to higher commodity prices creating cost-push inflation.

As fears of inflation infiltrate the markets, interest rates increase which raises borrowing costs.

As the dollar weakens, exports come under pressure which comprises about 40% of corporate profits.

Higher input costs, borrowing costs, and weaker profits ultimately force corporations to suppress wage growth to protect profits.

As wage growth is suppressed, particularly with a heavily indebted consumer, demand falls as higher costs, both product and borrowing costs, cannot be compensated for.

As demand falls, companies react by reducing the highest costs to their bottom lines: wages and employment.

As profits come under pressure, stock prices fall which negatively impacts the “wealth effect” further curtailing consumptive demand.

As the economy slumps into recession, unemployment rise sharply, demand falls, and interest rates decline sharply.