* 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 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
"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
" 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
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.