History never repeats itself, does it?
Will the three-day week make an unwelcome return? There are
worries Europe may be forced to introduce energy rationing this winter due to the war in
Ukraine and shortage of supply. As yet, there no such concerns for the UK – far less
reliance on Russian oil and gas is a help – but there are other echoes of the 1970s in the
market and economic environment.
An oil price shock, strikes, stagflation and a nascent structural
bear market could be pointing to a long period of underperformance for many assets.
The Russian invasion of Ukraine has magnified the slowdown in the
global economy and compounded the damage from the COVID-19 pandemic, says the World Bank
in its latest report.
As a result, the global economy is entering a “protracted period
of feeble growth and elevated inflation”.
“This raises the risk of stagflation, with potentially harmful
consequences for middle- and low-income economies alike,” the World Bank says.
The organisation believes global growth will decline from 5.7
percent in 2021 to 2.9 percent in 2022— significantly lower than 4.1 percent that was
anticipated in January. It is expected to hover around that pace over 2023-24.
1970s parallels?
The current situation resembles the 1970s in three key aspects,
according to the World Bank, which cites persistent supply-side disturbances fuelling
inflation, preceded by a protracted period of highly accommodative monetary policy in
major advanced economies, prospects for weakening growth, and vulnerabilities that
emerging market and developing economies face with respect to the monetary policy
tightening that will be needed to rein in inflation.
Of course, it’s a little too simplistic to draw direct parallels
between now and then.
Today differs from the 1970s in a number of ways, the World Bank
notes. Firstly, the dollar is strong, a sharp contrast with its severe weakness in the
1970s. This does not necessarily make matters better – a stronger dollar is likely to
exacerbate the problem for emerging markets – the third of the aspects cited by the World
Bank above.
It also notes that the percentage increases in commodity prices
are smaller; and the balance sheets of major financial institutions are generally strong.
The latter point is true for sure – post the Great Financial Crisis banks’ balance sheets
are in far better shape. This is not a financial crisis but one of the real world.
However, commodity prices could yet rise, putting more pressure on inflation.
More importantly, the World Bank goes on, unlike in the 1970s
“central banks in advanced economies and many developing economies now have clear mandates
for price stability, and, over the past three decades, they have established a credible
track record of achieving their inflation targets”.
A ‘credible track record’ for achieving inflation targets does
not exactly ring true today with inflation in the US, Europe and UK at around 8-9%.
Market lessons?
If this really is the beginning of a 1970s period of stagflation,
what does it mean for financial markets? For many, stagflation means the slow grind lower
of a structural bear market.
First, today’s market slide did not begin with a crash as, say,
we had in 2020. This is not dissimilar to the situation in the 70s. The second-longest
bear market in history started quietly in early 1973 during a period of rising inflation
and slow economic growth. October 1973 saw the OPEC oil embargo drive crude prices sharply
higher, and the broad stock market dropped a lot more. The grind lower continued through
to 1974 before prices began to rise again. But it was not until 1980 that the S&P 500
made a new all-time high.
Can investors therefore expect years of stagnant growth for asset
values, particularly stocks? Today has a lot of the 1970s about it, but it’s not an exact
copy. History never repeats itself, but it often rhymes.
Has inflation peaked?
With central banks tightening, the most important factor for the
outlook for both the economy and stock markets, is inflation. Only once the yield on
assets like stocks and bonds can keep up with the rate of inflation will financial assets
appeal.
Core PCE inflation rose 5.3% month-on-month in February but has
since ticked lower at 5.2% in March and 4.9% in April. Meanwhile, prices for bellwethers
including fertiliser, computer chips and shipping containers have declined lately. Chinese
producer prices – another leading indicator for inflation globally – have also retreated
somewhat. Mortgage demand in the US has dropped to a 22-year low as rates rise.
There are some signs that core inflation might be topping out,
but it is far too early to call victory – the latest CPI print from the US killed the
immediate peak-inflation narrative. There is currently far too much uncertainty and
consumer expectations are so pessimistic it is ludicrous to keep saying inflation has
peaked: those who are doing so have been saying it for months.
70s or 40s?
Today is also like the period immediately after World War 2,
which would be better news for investors in the stock market. This inflationary episode
was caused by the elimination of price controls, supply shortages, and pent-up demand. The
Covid-19 pandemic produced a similar effect. The inflation after WW2 ended after two years
as domestic and foreign supply chains normalised and consumer demand began to level off.
Also, from both a monetary and fiscal perspective, today looks a
lot like the 1940s. The rate of expansion in the monetary base is consistent with the
period of high inflation in the 1930s, 1940s and the 1970s, explained Paul Tudor Jones,
the veteran investor who made his name during the 70s. He also stressed that “fiscal
dominance was a key reason for inflation to flare up in the late 1930s and the 1940s when
the Fed was strong-armed to keep rates low and to monetise Treasury debt issuance well
beyond the economic recovery phase”. Most market watchers would agree that the Fed was far
too slow in removing stimulus once the recovery phase began – only now in June 2022 has it
stopped purchasing bonds. The process of normalisation will be rocky and we cannot ignore
the risks of a prolonged period of underperformance for stocks.