Investing in a Stagflationary Environment

I intend to get back to answering more reader questions, and doing it through posts.  I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.  Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.  There is always something to learn.

I was too young to appreciate the last stagflationary period.  Yet, I need to manage my portfolio.  My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.  I’m a Canadian based investor.  The simple solution is to pull in my exposure and be more Canada centric.  This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).  I also do not subscribe to the excessive weighting in gold as a major investment theme.  To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.  Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.  During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.  That said, I have read a lot on economic history, so I understand the era reasonably.  I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.  (Hi, Mom! 🙂 )  Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”  I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.  No way that project saved money on a net present value basis.  (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.   It paid to have your fixed income assets as short as possible.  Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.  Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.  Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.  You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.  Who can raise prices more than the cost of their inputs?  Producers of global commodities like oil, metals, etc., typically do well here.  Financial companies with short duration assets or exposure to hard assets should do better here.  Staples should do better versus durables.  Growth investing should beat value investing (uh, oh, what do I do?  All of my processes are geared toward value investing).   Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.  I occasionally like gold, but it’s not a panacea.  I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?  That’s why we diversify.  I don’t tie my whole portfolio to one macroeconomic view.  Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.  I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.  Diversify into foreign currency bonds.  Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.