Surviving Stagflation

05/19/2011 9:00 am EST

Focus: MARKETS

Jim Lowell

Senior Partner & Chief Investment Strategist, Adviser Investments

Investors are gravitating toward large-cap dividend payers and tax-free munis, but they shouldn’t ignore the defensive qualities of small-cap growth stocks, writes Jim Lowell of Fidelity Investor .

Defense appears to make the most sense.

Recent fund flows show some smart buyers of muni-bond funds, set against a backdrop of a ton of sellers of most everything else.

But it’s interesting to note that the selling doesn’t cover everything; in fact, there’s been only a slight nudge for selling of diversified stock funds, growth funds, and growth and income funds, while there remains notable selling in taxable bonds and cash.

Seeking the yield absent in most taxables, a flight to utilities is evident. Not that utilities aren’t less interest-sensitive; they’re prone to any hike. But tomorrow’s risk appears to be overlooked in favor of what can yield more today.

Overall, the flows suggest a lack of conviction on the equity side of the fence.

Meanwhile, China is moved to position another loan-reserve hike in an effort to slow its growth. Brazil raised its benchmark interest rate to 12%, its third quarter-point rate hike this year.

Commodity prices are screaming inflation in a Fed forest where no one seems to be able to hear: Inflation isn’t abating in the hottest growing region of the world. Meanwhile, here at home, inflation in more than just food and energy are cropping up—yet our Fed continues to suggest that any signs of inflation will be temporary. I hope so, but I don’t think so.

Given the woeful jobs market, the theme of stagflation can’t be as easily dismissed as I’d hoped.

When inflation rises, and bonds lose their appeal, yield seekers tend to turn toward dividend-paying stocks—even more so if stagflation wrangles its way onto the field. Growth-oriented, mega-cap multinationals and smaller-cap growth companies have fared well in past bouts of these contenders.

They look to be even better positioned this time around, given:

  • their battleship balance sheets
  • competitive dividends with more traditional, value-oriented, dividend-paying sectors
  • global growth plays
  • and ability to offset inflation here with foreign-exchange rates in the global marketplaces they trade in

Small-cap growth is a sector that most analysts I speak with are shunning in favor of large-cap stocks, partly on the assumption that they’ll fare worse in an inflationary environment.

I don’t share that view. I think small-cap growth companies with good balance sheets have not only proven their bear-market mettle, they’ve also learned a new trick or two for how to grow in what are still tough times. Moreover, many small-cap growth companies are emerging multinationals.

There is no dividend play in the small-cap camp, but I still think the other attributes offset the fact that yield tends to be the driver of investment decisions in inflationary and stagflationary times.

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