European stocks may face stagflation threat in 2013

Threat

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.

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