European stocks may face stagflation threat in 2013
* Some see stagflation threat as growth stagnates
* Excess liquidity heightens inflation fears
* Equities can outperform in inflation sweet spot
* Small caps, quality and value stocks top picks
By David Brett
LONDON, Dec 18 (Reuters) - Central bank easy money should support appetite for equities in 2013, but relatively high inflation in a low-growth world marked by high unemployment may yet spoil the party.
That toxic mix - termed stagflation when it reaches extreme levels - could hurt demand for stocks, but currently lags U.S. budget talks, the euro zone debt crisis and Chinese growth in investors' list of risks.
While there is little expectation of a return to the stagflation of the 1970s and early 1980s, some analysts say the flood of central bank cash could see inflation accelerate at a time of anaemic growth and take a toll on share prices.
Pressure on sovereign bond yields caused by the central bank largesse is already pushing investors into higher-yielding assets in search of a return, and with more stimulus expected, demand for stock dividends is set to grow.
That could leave some shares vulnerable if costs begin to rise and relatively high profit margins have to be trimmed as cash-strapped consumers prove unwilling to pay higher prices for companies' products.
"We are running into a stagflationary scenario and usually that is not a good environment for strong equity market performance," Johannes Reich, head of equity research and strategy at Bankhaus Metzler, said.
All of which could see investors turn to the strategies that have historically done well during such a period, including bets on smaller companies, those that are relatively cheap, as well as those with a particularly strong balance sheet.
Inflation in the euro zone is around 2 percent, in line with central bank targets and far from the double-digit levels of previous stagflationary periods.
While inflation expectations remain anchored, volatility on those levels has increased, suggesting the market's belief in the ability of central banks to control inflation is being eroded, analysts at UBS said in a note.
Given the weak growth outlook, with the euro zone expected to flatline next year after shrinking 0.5 percent in 2012 , and with unemployment in the region in double figures, some see an extended period of stagflation as possible.
Stagflation has been cited as a concern by global fund managers polled by Bank of America Merrill Lynch, while the Bank of England has warned that Britain faces the "unappealing" mix of a weak recovery and high inflation..
The impact on inflation of the billions in new money has been acknowledged by the U.S. Federal Reserve. It pledged to keep interest rates steady until unemployment fell to at least 6.5 percent - as long as inflation did not break above 2.5 percent and broader inflation expectations were contained.
Stagflation , which has no precise numerical definition, was most pronounced in the 1970s and early 1980s when soaring energy prices delivered a shock to the global economy.
While there is no evidence to suggest the global economy will suffer this time on such a scale, the uncertain impact of the slew of central bank stimulus has led some analysts to see stagflation as a growing threat.
"Arguably we are in a somewhat stagflationary regime," Mouhammed Choukeir, chief investment officer at Kleinwort Benson, said.
" Asset classes that will do well are specific equity strategies, namely higher quality stocks, and value stocks and typically commodities. Small cap equities...also do well."
Firms with a stronger balance sheet or other fundamental strengths - so-called "quality" stocks - can weather economic storms better, while relatively cheaper, or "value", stocks have, arguably, less distance to fall compared with their peers.
Smaller firms, meanwhile, defined by Kleinwort Benson as those with a market capitalisation of between $300 million and $2 billion, normally avoid the cull by being able to adapt their business to a tougher economic environment more quickly.
All three styles of investing have seen gains in recent weeks, although the degree to which that is due to concerns over stagflation is not clear.
The STOXX Europe 200 small companies index, for example, is up 17.2 percent in 2012 against 13 percent for their blue chip peers.
Value stocks have also enjoyed a resurgence despite concerns about economic growth, thanks to gains by the banking sector on the back of European Central Bank plans to backstop the euro.
The MSCI Europe Value index is up 15 percent, while banks, heavily underweighted since the credit crisis began in 2008 and thus historically cheap, are up 22 percent.
While stagflation can hit demand for equities, inflation can support stocks - as long as it is accompanied by growth.
That "sweet spot" for inflation is traditionally between 2 percent and 5 percent, analysts at UBS said in a report, but beyond that, costs become too high to pass on to consumers.
When that point is reached, stocks should see interest from debt investors as inflation eats into returns from bond yields.
"At some point inflation will happen. When is a tough question, but with the amount of cash on the sidelines and with relatively few funds owning equities we could see a rush into that asset class when it does," James Burns, head of the multi-manager team at Smith and Williamson, said.