Stagflation in the US: The ghost of 1970s is back to haunt U.S.

Does the US need to worry about stagflation?

24 Mar 2016 (Marketwatch) - Bank of America warned that investors should at least prepare their portfolios for the possibility of stagflation.

1 Aug 2017 (Bloomberg)  - Greenspan Sees Return of Stagflation

Stagflation is a rare occurrence. It is a double stab of persistent high inflation and almost zero growth in a country’s economy. The last time we saw this happening in the U.S. was during 1974 -1975, where the average inflation was 10%, average unemployment of 7.1%, and negative real GDP.  On hindsight, the oil supply shock was attributed to be the main cause of the period of stagflation, pushing costs way overhead and as a result locking the entire economy in gloomy stasis. This time, it is possible that when Fed starts to unwind their $4.5 trillion balance sheet, the long term rates rise rapidly, directly creating inflation.

We should make plans to handle it, despite their repeated assurances.

How should we prepare for stagflation, if it really comes true?

Roughly 30% of that are Treasuries with less than 5 years of maturities. According to Fed’s plan of letting them mature naturally, it will take 4-5 years to halve the balance sheet. There are no plans to sell these bonds in the open market, they say. But just how independent is the Fed under Trump? (Note: Members of the Board of Governors of the FED are nominated by the President and confirmed by the Senate)

The unwind or maturing of Fed’s position will reverse the entire Asset price inflation over the past ten years. Everything I see from bonds, equities, properties, art and wine will experience a price correction towards the mean. The boring ones may see a simple adjustment (15-25%). That nice Monet painting from the last auction will probably face a discount of 70-80%. Well then, cash is King. Consider allocating 20% of portfolio into cash or equivalents and standby to benefit when asset prices decline in tandem.

As for commonly held inflation hedging methods, I am not against them. They should work well in general scenarios, but stagflation in a developed economy is rare and nowhere near general.

Studies have shown that inflation-hedging characteristics of core Assets failed to perform in episodes of unexpected inflation. Brueggeman et al, 1984. “Real Estate Investment Funds: Performance and Portfolio Considerations”

Stagflation’s impact on assets is similar to that of inflation with the added risk that the accompanying economic contraction spells more downside. In this environment, being up the capital stack in mezzanine would protect against downside while offering key control rights to navigate and protect the investment. Dan Heflin, Torchlight Investors LLC

Therefore, it is good to rethink where along the Capital Stack to allocate the remaining 80% of portfolio. Less on the top-most and bottom-most levels; Equity & Senior Debt.

Switching to Preferred Equity from Equity gives a higher claim on assets, and a possible retainment of dividends. Think Buffett and Goldman Sachs in 2008.

Switching to Mezzanine debt from Senior debt gives a higher yield to buffer against the pace of rate hikes. Provided company doesn’t bankrupt and the buffer doesn’t wear out too soon.

The sweet spot over the next couple of years, probably lies between allocating in Preferred Equity and Mezzanine Debt, with the remainder in cash equivalents. In this manner, we can prime ourselves to pick up assets at good value once the price normalization kicks in. Herein credit risks are crucial. An in-depth study of the respective company’s business, cashflow, management’s expertise and business strategy should be kept up-to-date and closely evaluated.