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`Stagflation` is a possibility now
GLOBAL MARKETS/ SHORT VIEW

John Authers / London May 28, 2008, 2:52 IST



When traders return to their desks in London and New York today, they will face the aftermath of the worst week for stock markets since February.


It appears to have ended a rally that had lasted since the Bear Stearns fire sale in March. Triggered by relief that no other bank followed Bear into the abyss, the rally owed its recent gains to broader factors, such as optimism on earnings and the economy.

The S&P 500 regained 14.6 per cent from its Bear nadir; it has now fallen 4.7 per cent from there. The S&P financials rose 24.6 per cent but has given half of that back, down 12.8 per cent from its recent peak.

What punctured the optimism? US housing, with no signs of hitting a bottom, has much to do with it. The homebuilders had rallied 63 per cent - they have since dropped 26 per cent.

But it is the oil spike, above all else, that has caused a rethink. It raises "stagflation" as a possibility, by braking economic activity while boosting inflation. It also raises the toxic scenario for financial markets that the Federal Reserve may have got it wrong and that rates will soon rise.

Those who like charts might try comparing the S&P since it peaked in October with the way it behaved in 1973 and 1974 when, as now, an oil spike combined with fears of stagflation.

So far, stocks have moved much as they did in 1973. That is concerning, as 1973-74 proved to be a nasty bear market, with a fall of almost 50 per cent.

The way to make money has been in oil and emerging market stocks seen as commodity plays, particularly Brazil (up more than 50 per cent in dollar terms since January).

At one point this was a strategy to benefit from "decoupling" - the rise of emerging markets as alternative engines for global growth. It has now morphed into a strategy for hedging against stagflation.