The term “inverse stagflation” is not widely quoted among the popular financial press. That’s because most investors and analysts still believe the industrialized economies are in a period of 1970s-type stagflation. That’s not necessarily the case, a point I’ve argued in this column over the last several months.

Inverse stagflation is a twisted version of stagflation. The latter is defined as a period of rising inflation accompanied by flat or sluggish economic growth. Stagflation dominated the 1970s whereby the United States and Europe were mired amid soaring commodity inflation, stagnant economic growth and rising wages. But it’s not entirely accurate to label the current macroeconomic environment as strictly stagflation.

In the late 2000s, stagflation has an evil friend called deflation.

Although the United States and, increasingly, Western Europe are increasingly being pulled into stagflation, a growing housing crisis and the contraction of bank credit are deflationary forces working to cool rising inflation, at least to an extent. Europe, unlike the United States, currently suffers from a bad dose of renewed wage pressures, ultimately forcing the European Central Bank or ECB to hike rates tomorrow.

Increasingly, the Europeans are being pulled into an economic slowdown. Some countries are already technically in recession, defined as two consecutive quarters of negative GDP growth. Denmark and Ireland are now officially in recession while Spain, France and Italy are approaching contraction. In England, the economy is also slowing sharply and will likely fall into recession this year.

If falling real estate values and rising food and energy prices aren’t enough for the ECB, the surging euro is causing all sorts of economic challenges.
The single currency continues to strengthen this year, depressing Euro-zone exports at precisely the worst time.

Europe is now facing heartache. This helps to explain why stock prices are down more than 20% across the Continent in 2008 compared to about a 13% in the United States. Earnings expectations remain too high in Europe. A strong euro will continue to depress European corporate earnings this year combined with weak consumer spending.

Global stocks look increasingly attractive compared to bonds as the bear market intensifies. But it’s still too early to be aggressively shopping for bargains until oil prices cool off.

Europe, like the United States, is now comfortably entering inverse stagflation. This promises to be a volatile summer. Stay defensive and underweighted stocks.