How to Invest in the New Era of Stag-Biflation

Move over stagflation, and as for Nouriel Roubini's stag-deflation, we hardly knew ye. The U. S. economy is suffering from stag-biflation.

During the 1970s, the prices of everything, from houses to oil and labor, rose. Economic stagnation plus inflation gave rise to the new term, stagflation. This is not the same environment. The U. S. had been scared into a (temporary) era of fiscal prudence following the 1930s and then the debt "binge" of World War II. But none dare call this prudence (see chart, plus LINK):

Unlike the 1970s, home prices are dropping and unlike the 1965-81 era, Treasury and other bond yields remain in the downtrend channel that was established in the 1980s. This era is different, therefore, from the 1970s, and I believe it's time we helped clarify our thinking by refining 'stagflation' into what I have somewhat inelegantly proposed as stag-biflation.

Many of the largest financial institutions in the country were found to have little or no real capital after all their bad loans, bad assets, etc. were properly valued.

Most of the nation's largest banks are, as standalone entities, too weak to expand credit much (LINK):

Moody's has affirmed the C- (C minus) standalone bank financial strength rating (BFSR) of each of Bank of America and Citigroup, and affirmed the C+ (C plus) BFSR of Wells Fargo.

It is a race against time for such a weakened financial system to sustain other than a continued deleveraging of housing finance. At the same time, the economy is two years from the trough of economic activity and is decelerating, with housing activity having dropped yet again. However, all the new money creation of the past few years that has largely financed the exploding Federal spending documented above has found its way into prices for almost every that people buy regularly without resorting to large bank loans (e.g. home mortgages and, secondarily, cars).

This is a scary period, because "money in the bank" is not safe. If the banking arms of BofA and Citi are C minus already, what capital will be available to support deposits if it turns out that their assets decline in value from here, such as from another deflationary recession?

What may await us in the financial markets in the months ahead? Here are some thoughts.

In the U. S., the weakened financial institutions may well be "encouraged" to "improve" their balance sheets by adding massive amounts of Treasurys to them. The bank regulators will point out to bank management that Fannie and Freddie are now strict rather than loose with their money, commerical real estate is glutted, and the Fed is on hold with a zero interest rate policy for an increasingly extended period. Thus, shouldn't the banks bite the bullet and invest in 10-year Treasurys at 3%, at a time when they are paying more or less nothing to their depositors? After all, a spread is a spread. And, there are no loan committees needed to evaluate each loan case by case. So, it's all profit for the banks. There are no costs: no tellers, no need for branches, etc. I think it will happen and for a while allow the Fed to keep its promise of no QE3 per se.

Short-term Treasurys yield next to nothing, but if that circumstance can continue year after year, one loses less to price inflation by owning a longer-term security.

The only other major asset class that makes sense for me to have a substantial allocation of financial resources in today's environment is gold. All government-mandated money is based on debt issuance, and gold is thus the only monetary asset that is no one's liability. It is wealth in an idealized form that individuals and governments worldwide both agree has enduring value. At several different times in the 20th Century, and as recently as 1980, gold bullion and mining shares have had an order of magnitude greater weighting in global financial asset valuations than today. I have seen number of 30% of the entire value of financial assets being gold-related in 1980 compared with under 2% today. Gold therefore has vastly more upside potential relative to other financial assets. Relative to alternative investments, gold is not even close to being fundamentally in bubble valuation territory. It's basically only doubled compared to its high price of 31 years ago. Not.A.Bubble.

Stocks, though, look to be challenged here as the stock market tends to move with acceleration or deceleration of economic activity, though I have begun loading up on McDonald's again, a stock which I have praised a number of times on this blog beginning in spring 2009. MCD has for several years traded with a dividend yield that tracks the 10-year Treasury yield. If that relationship continues, and if the 10 year Treasury yields 2.5% late this year (same as in 2010) while MCD raises its dividend 10% as it has been doing year after year, then its stock price could go from about $80 today to about $100. MCD has been a beneficiary of rampant monetary inflation and the stock should benefit should commodities do what they should do after the massive cash-out profits the Glencore (commodities firm once controlled by Marc Rich) crew took out of their recent IPO (i. e., commodities should trend down in price)

Other stocks, almost all dividend payers, make sense but MCD is my favorite, and I think that most investors should wait for lower stock prices before allocating much capital to the "market". One of these days, there likely will be another period of revulsion toward stocks, which is when brave investors move in to seize bargains. As we have seen in Japan, stocks cannot rely on ultra-low interest rates to keep share prices high. A 20-50% drop in stocks from here in the setting of an "ordinary" recession is quite a reasonable assumption. How many years of today's sub-2% dividend yield on the S&P 500 does it take, again, to make up for even a 20% drop in prices, even if dividends rise 5% a year? (I don't know exactly, but the answer is "too many" to suit me.)

In summary, the months ahead look likely to hihglight the deflation side of biflation, with a "healthy" dose of stagnation added on to too much recent excitement in commodities while the smart money a la the Glencore folks has been on the sell side. Supply-demand characteristics suggest that the U. S. financial system will absorb the supply of Treasuries and that Treasury bond prices can easily reach those of last year, allowing traders who jump in now to look at possible large percentage profit months out. While gold remains the optimal investment for the years ahead, it may have trouble rising further if oil and copper tumble.

In the scenario laid out above, cash is not as much "trash" as it has been for some time.

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