Thursday, February 28, 2008

Stagflation - Stagnation and High Inflation

The term "stagflation" has reared its ugly head once again, after being almost unheard of since the 1970s. Basically, the term is actually a combination of the two words "stagnation", which refers to economic slowdowns akin to recessions; and "inflation", which means steadily increasing prices which erode the value of today's dollar. As mentioned in an article in BT today, stagflation gets very toxic and dangerous if it is prolonged and saps the entire economy and population of spending power and resources. Normally, recessions and economic slowdowns are supposed to (according to economic theory) have a negating effect on inflation.

So why is stagflation coming into the picture right now ? From what I've noticed, many companies (including several "prominent" China ones like Jiutian and Synear) are facing increasing cost pressures as the prices of commodities such as oil, wheat, pork and steel rise unabated. This is a good example of worldwide commodities inflating due to strong demand and lack of supply, and this inflationary pressure is likely to continue for quite some time (or so the experts say !). Thus, it will be good to get a handle on the current situation as it applies to companies you own, in order to see if there will be any adverse impact. Already, forecasts are being revised and expectations lowered for the forseeable future till more earnings and margin clarity has been established. As a result, I am also cautiously examining the companies I own to see if they will be greatly affected by increased costs. My margin of safety should provide sufficient cushion against any business downturn, but the key is to see if the effects will persist over the long-term or if it is just a short-term anomaly.

The US economy is also heading for slower growth, and some economists and analysts are predicting a mild recession which should end by FY 2008. The sub-prime problems have led to the collapse of the housing market bubble and home prices are falling across the board, leading to record foreclosures. Banks, financial institutions and bond insurers have had to deal with worsening credit conditions and assets on their books which cannot be valued, thus the impact will be great and will last for some time since there is quite a lot to write-off and write-down. As a result of the weak economic data flowing from the USA, the USD has been sold off sharply in recent days, hitting a new 11-year low of 1.397 against the SGD. The combination of high oil prices, slow to zero growth and a weak dollar have not been seen since the oil crisis in the 1970's, when oil prices also surged to an inflation-adjusted price of about US$103 per barrel.

In times like these, risks are being perceived as being more significant, and everyone is more cautious with investing in companies as companies will undergo cost pressures and possible bad debts as their customers may face cash crunches. Thus, a re-pricing of risk is being done and many companies on the SGX now trade at single-digit PER. This is to be expecte in view of the macroeconomic environment and is part of the business cycle, so one should not even pay too much in the first place to purchase a stake in these companies.

As long as one is prudent and objective in assessing a company's potential and purchases with a margin of safety, one does not need to fear a permanent loss in capital. Of course, a long-term view is also encouraged as Mr. Market can be very manic in the short-term (which is defined as "over-reaction bias" which I will cover in future under my "Behavioural Finance" series).

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