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Stagnation + Inflation = Stagflation


The Federal Reserve’s Federal Open Market Committee (“FOMC”) balked at raising its federal funds (interest) rate last week despite what appears to be accelerating wage inflation. In its policy statement, the FOMC indicated:

. . . the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives.

Inflation Liftoff?

With inflation still being low, it appears the FOMC thought it could be patient and wait for more evidence of rising inflation before in raising interest rates. The evidence appeared to have arrived only days later. The Bureau of Labor Statistics last week reported wages grew at the fastest pace since the recession. Average hourly earnings in October, compared to a year earlier, increased by +2.8%, which was the most in more than 7 years.

In fact, the former Chairman of the Federal Reserve, Alan Greenspan, indicated just yesterday he thinks we are about to witness inflation liftoff. On November 7th, when asked about how long the bond bull market can continue, he said in an interview with Bloomberg (emphasis added):

“It may very well be the fact that we are moving into the very early stages of inflation acceleration.” – Alan Greenspan (November 7, 2016)

What is Stagflation?

With inflation potentially beginning to accelerate in the face of very weak economic growth, it would appear the U.S. may be entering a period of stagflation. You don’t hear about stagflation too often but it was something experienced in the 1970s that was made worse by the OPEC oil embargo. Stagflation occurs when there is persistent inflation combined with stagnant demand and relatively high unemployment.

It is still too early to say there is stagflation in the U.S. but there are certainly signs that point to it. In addition to rising wage inflation, labor market conditions have seemingly begun to deteriorate and economic growth is most certainly very weak. Furthermore, demand looks stagnant. For example, import growth has turned negative despite a strengthening U.S. dollar that effectively makes imports cheaper.

Cutting Back on Capital Investments

Another indication of weak demand is coming from the private sector. In particularly, private sector investment is in noticeable decline. What this means is companies are investing less and less in their productive capacity. You can see this in the graph below.

Meritocracy Capital Partners Stagflation Stagnation Inflation Capex Capital Investment Business Investment Net Domestic Private Investment Howard Ma CFA

Net Domestic Private Investment has rolled over again to a degree that is very consistent with past recessions

As illustrated in the right side of the graph above, net domestic private investment (“NDPI”) (blue bars) in the current business cycle seems to have peaked at USD$573 billion (seasonally adjusted) in the quarter ending January 2015. Six quarters later in the quarter ending July 2016, NDPI declined to USD$385 billion (seasonally adjusted). That is a decrease of 33%. Six quarters of decline combined with a 33% drop has historically proved recessionary.

Consider the evidence. In the previous 7 recessions since the 1970s, NDPI peaked before decreasing by a median of 14% before the start of those recessions. Furthermore, recessions started by a median of 3 quarters after NDPI peaked. By historical standards, the U.S. is in a deep investment recession.

What is also interesting is the trend looking back more than 50 years. In the mid-1960s when the U.S. economy was more reliant on manufacturing, NDPI/GDP (orange line) peaked at 7.1%. During the Tech Boom era when the U.S. economy was more service-oriented, NDPI/GDP peaked at 5.5%. The trend is clearly downwards.

In fact, during the Global Financial Crisis, NDPI/GDP actually went into negative territory. Since the economic recovery, NDPI/GDP has improved but it appears to have peaked once again but at only 3.2%, which is less than the previous business cycle peak of 3.4%. NDPI/GDP has most recently decreased to 2.1%. Given the downward trend, it is not clear if a 2.1% is a signal for a recession. Nevertheless, this level has certainly coincided or lagged recessions in the past.

As mentioned earlier, U.S. import growth is now negative. This includes investment in capital goods, too. According to an article published just yesterday from economists at the Federal Reserve Bank of New York (emphasis added):

Equipment investment has been unusually weak, with its four-quarter percentage change falling into negative territory, which is unusual outside a recession period. These data suggest that the slowdown in import growth likely stems from whatever is behind the weakness in equipment, rather than from trade-specific factors such as trade policies or higher trade costs.

Whether or not you find a decline in net domestic private investment to be recessionary, please consult an investment fiduciary before making any investment decisions.

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