Is Europe At Risk of Stagflation Now?

10/24/2011 10:37 am EST

Focus: GLOBAL

Gemma Godfrey

Head of Investment Strategy, Brooks Macdonald

Stagflation risk is rising in the UK and across Europe, but few have discussed what this means for stocks, notes Gemma Godfrey of The Investment Insight.

As the outlook for growth continues to deteriorate while the prices for goods and services remain stubbornly high, the risk of stagflation returns. This would be a tough scenario, where policy options tackling one of these issues would only worsen the other.

This creates substantial downside risk for stock valuations based on bullish growth forecasts, while making it more prudent to invest in price makers able to pass on rising input costs.

Lower Growth Outlook
The outlook for growth is bleak. The IMF has reduced their forecast expansion of Europe from 2% to 1.6%, and Goldman Sachs swiftly followed suit by predicting France and Germany will fall into recession next year, with the EU stagnating.

The data looks supportive of this view. German retail sales disappointed expectations, with a contraction of -4.3% in July vs. -0.5% expected. With Europe still the UK’s largest trading partner, the effect in Britain could be severe.

Outside the EU, countries aren’t immune. China’s Purchasing Managers Index has fallen below the 50 mark, the line separating expansion from contraction, and GDP growth came in at 9.1%, falling from 9.5% and below expectations.

QE Increases Stagflation Fears
In an effort to boost the economy, the Bank of England surprised many commentators by increasing its purchases of UK government bonds from £200 billion to £275 billion ($438.4 billion).

However, this is not without its risks. It is not a guaranteed strategy to boost growth and crucially create jobs. Instead, it is more likely to increase inflation.

Taking bonds out of the market and pumping cash in their place only reduces the value and purchasing power of the currency, making goods and services more expensive. Inflation is already above the 2% target set for price stability, hitting a rate of 5.2% at the latest measure this week.

In the EU, the value jumped to 3% in September, the fastest increase in three years, and potentially a reason behind the European Central Bank’s decision not to cut rates.

Unemployment in stagnating economies is an issue and highlights the threat. Spain is struggling, with one in every five of their people without a job, increasing to 45% of the youth population. Portugal’s jobless level has reached highs not seen for over two decades.

The US September figures are stuck at 9.1%, although CPI came in below expectations. Here in the UK, the level might "only" be 7.9%, but this is still high—and stubbornly so, with inflation surprising on the upside.

The stagflation quandary (where stagnation and inflation meet) is that to tackle unemployment and boost growth, interest rates would be cut. However, not only are they already low, but that would boost inflation even further.

Likewise, to tackle inflation, interest rates might be increased, but this would only hurt growth and employment. It’s a lose-lose situation.

Risk of Stock Downgrades
So what has this meant for stocks? First, there is downside risk to stock valuations. With many valuations based on forecast growth, downgrades could negatively impact and seem more expensive.

Analysts are ten times more bullish on the growth outlook than economists. Although they’re always more optimistic, that is twice the historical average.

Secondly, it may be more prudent to invest with those that are price makers, not price takers, as well as with a protected demand base, in order to be able to pass on rising costs.

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