Please see article below from Brewin Dolphin – received late yesterday afternoon – 16/03/2022.
Are we heading towards 1970s-style stagflation?
A growing number of investors are beginning to worry about a return to the environment that characterised the 1970s. Both Otmar Issing, the European Central Bank, s first chief economist, and Larry Summers, former US Treasury secretary, have recently flagged stagflation risks (weak growth and high inflation). Could things get this bad? Paul Danis, our Head of Asset Allocation, discusses below.
What was the economy like in the 1970s? The 1970s was a decade plagued by high inflation. The oil crises of 1973/74 (following the OAPEC oil embargo) and 1979 (following the Iranian revolution) made an already challenging inflation backdrop worse. The spike in energy costs in each crisis left consumers with substantially less disposable income to spend on other goods and services, which weighed on consumption.
Industrial action in the UK was particularly severe in the 1970s. The coal miner strikes early in the decade restricted supply, resulted in blackouts, and forced businesses to close. Ultimately, the government of Edward Heath imposed a three-day week, further weighing on growth. The widespread strikes in the ‘Winter of Discontent’ later that decade led to major disruption, with graves left undug and rubbish piled up in the streets.
High inflation eventually forced central banks to aggressively raise interest rates, which weighed heavily on the interest-sensitive areas of the economy. This combination of high inflation, weak demand and rising long-term interest rates was toxic for financial markets, and led to very weak ‘real’ asset returns (the return that is left over after subtracting inflation).
Just how bad were real returns?
Taking the US as an example, annualised real returns were negative for stocks, cash, government bonds and corporate bonds in the 1970s. In the case of equities, the annualised real return in the decade amounted to -1.5%, which compares to an approximate +7.7% annualised real return over the 100 years leading up to today. Conversely, returns on commodities such as gold and oil were much stronger than average in the 1970s.
What caused the high inflation of the 1970s?
A perfect storm of factors led to the high inflation 1970s. Sticking with the US as an example, government expenditure rose on the back of both the Vietnam War and President Lyndon Johnson’s ‘Great Society’ legislation, with the latter involving higher government spending on social programmes.
When the gold standard came to an end in 1971, the US dollar was able to float freely. The greenback dropped sharply over the next few years, pushing up import cost inflation. President Richard Nixon pressured then Federal Reserve chairman Arthur Burns (who was previously Nixon’s economic adviser) to maintain an expansionary monetary policy heading into the 1972 election, despite a growing inflation problem. Burns complied. Nixon also introduced wage / price controls in the early 1970s in a bid to get inflation under control. While temporarily slowing inflation, these measures led to shortages and so ultimately made the problem worse.
The oil crises of 1973/74 and 1979 reduced global oil supply and drove up petroleum prices. Meanwhile, real-time estimates overstated the ‘potential output’ of the US economy. This led policymakers to believe there was more ‘slack’ (unused resources) in the economy, which caused them to underestimate the inflationary effects of their policies. Finally, labour union worker contracts typically were linked to inflation. This setup produced a ratcheting effect when price increases picked up.
What was happening in the UK?
As was the case in the US, mismeasurement of the ‘output gap’ (the difference between actual output and the level of output consistent with sustainable full employment of resources) was a problem for UK policymakers. A Bank of England (BoE) working paper concluded that monetary policy errors due to this problem contributed about 3.0 to 7.1 percentage points to average UK inflation in the 1970s (Nelson / Nikolov, 2001). Meanwhile, the BoE was not independent. Several studies have established a significant link between the level and variability of inflation and the degree of central bank independence. Both the oil supply shocks and effects of wage indexation played a similar role in pushing up UK inflation as they did in the US.
Are there parallels between the 1970s and today?
Some of the factors that contributed to the high inflation of the 1970s are prevalent today. Labour markets across the developed world are tight. In the US, the unemployment rate heading into the 1970s was 3.5%. At present, it is 3.8%, and likely to reduce further.
The US has enacted massive fiscal stimulus under President Joe Biden at a time when the economy was already expanding rapidly. Global oil prices have surged, most recently on the back of Russia’s invasion of Ukraine. This will bolster inflation, and weigh on growth.
That said, there appear to be more differences than similarities. Central banks today are probably less likely to give in to political pressure. The Federal Reserve restored its credibility under Paul Volker, who quashed inflation after taking charge in August 1979. That credibility largely remains intact. Central banks have formally adopted inflation targets. Households, businesses and investors believe they will take steps to reduce inflation if inflation expectations were to become ‘de-anchored’. Meanwhile, developed world economies are now structured in a way that makes a wage / price spiral less likely. Union power has declined as economies have become more service oriented, and wage indexation is built into a much lower percentage of contracts today. Wage / price controls seem very unlikely. Importantly, the current ‘oil shock’ is nowhere near as bad as either of the two that occurred in the 1970s. We believe that supply concerns linked to the war in Ukraine have boosted the oil price by around 10%. This is far less than the 237% supply-driven rise in 1973/74 and 154% in 1979.
How do you expect the economy and markets to evolve?
Absent an escalation in the Ukraine crisis that causes energy prices to surge anew, it is likely that inflation in the Western world will moderate as the year progresses. Supply bottlenecks should continue to improve, the impact of last year’s fiscal stimulus should wane and monetary policy will tighten. That said, inflation is likely to remain uncomfortably high. Even without additional upside, the process by which commodity inflation filters through to consumer prices should last for some time. Tight labour markets should bolster wage inflation, which will encourage businesses to raise prices to protect profit margins. So-called shelter inflation pressure (categories related to rent and imputed rent) will also likely remain strong.
Regarding growth, we believe that 2022 should see most developed world economies grow at a solid pace. However, the rise in energy costs and inflation more broadly should combine with rising interest rates and slower job growth to weaken the pace of the global economic expansion.
On markets, we continue to expect stocks to outperform bonds. However, the economic cycle has moved into a later stage. As such, we expect to use periods of market strength to lighten our equity exposure.
What about longer term?
Although a repeat of the 1970s seems unlikely, there are good reasons to have subdued expectations with regards to longer-term economic growth prospects. Demographics are a headwind, as labour force growth is likely to be weak.
Meanwhile, we suspect that longer-term inflation risks lie to the upside. Entitlement spending (healthcare, pensions) for ageing populations will require continued deficits. There is a risk that these may end up being partly financed by central banks via additional quantitative easing, which would amount to moneyfinanced fiscal policy. Globalisation headwinds are mounting, and the age structure of populations is shifting so that the ratio of workers relative to consumers will fall. Both developments risk higher inflation. The process of decarbonisation of the global economy also risks boosting inflation over the longer term.
Subdued growth combined with rising inflation risks suggest that equity returns over the next decade will likely be much lower than investors have grown accustomed to since the 1980s. But even so, we would still expect equities to be a better investment than cash over the long term.
Please continue to check back for our latest blog posts and updates.
Charlotte Clarke
17/03/2022