Investors could learn the wrong lessons from the 1970s.
It’s hardly a fond memory, but rising prices in the US and other countries this year have investors and experts looking to repeat the “stagflation” of the 1970s – a demoralizing combination of stagnant economic growth and high inflation. The comparisons are understandable but superficial and offer little insight into what is actually going on beneath the surface, said Jean Boivin, head of the BlackRock Investment Institute, in a telephone interview.
Why is it understandable? “We haven’t seen an environment since the 1970s in which inflation was mainly driven by supply shocks,” said Boivin, a former deputy governor of the Bank of Canada. But that is where the comparisons largely end.
Inflation in the 1970s was exacerbated by oil embargoes, which drove up energy prices, slowed the economy and fueled inflation. In the current case, the supply shocks are largely the result of a surge in demand tied to restarting the global economy after the COVID-19 shutdown. That’s an important difference.
In fact, the 1970s and the current situation are contradictory in many ways, Boivin said. Stagflation came half a century ago when growth and activity exceeded the productive capacity of the world economy. Now the economy is running into supply chain bottlenecks, which is not the same. In fact, the economy is still operating below its production capacity, he said.
That means that supply will eventually increase to meet demand, he said rather than the 1970s experience that demand will decrease to meet supply.
And while both episodes share rising oil prices, the story in the 1970s was one where producers’ shutdowns of oil supplies slowed the economy and undermined their operating capacity. Energy prices are rising now because the economy is up again, “and without energy there is no way,” Boivin said. “The causality runs in the other direction.”
Other economists have made similar statements.
“To be in stagflation, the economy has to be stagnant by definition, and the evidence for that is pretty thin,” said Neil Dutta, head of US economics at Renaissance Macro Research, in an October 18 release. “According to all information, the economy remains firmly in boom mode.”
To identify signs of stagflation, Dutta used the indexes for incoming orders and prices paid by the Institute for Supply Management.
On one axis, he placed new orders that act as a proxy for the demand side of the equation or how many customers buy. On the other hand, it represented the prices paid as a proxy for inflation (see table below).
Macro Research of the Renaissance
In order for the economy to stagnate, orders need to be below their long-term average – reflecting weak customer demand – and prices need to be paid
above its long-term average – which means inflation is high, Dutta explained. Instead, as the red dots for the 2021 monthly readings show, the economy is in an “inflation boom,” he said, with strong orders and strong prices.
And then there is the job market. Indeed, part of what drove the “stag” into stagflation in the 1970s was the high unemployment that came with rising prices.
“At 4.8% today, the unemployment rate is below its 5, 10, 15, 20, 25-year averages (and so on; you get the picture),” wrote Ross Mayfield, investment strategy analyst at Baird , in a Monday note.
“While the economy still has a few million jobs removed from the pre-COVID era, the number of job vacancies is at record levels and churn rates are skyrocketing,” he said.
Political mistake ahead?
That doesn’t mean inflation is not an issue. And rising inflation expectations, a key metric monitored by central bankers, could become a problem. Boivin fears that some policymakers will react too quickly and aggressively to increases in inflation for which monetary policy is not prepared.
That would risk unnecessarily destroying demand if bottlenecks were to resolve themselves and supply should come back, said the former monetary politician. After all, tightening monetary policy would do little to decongest the port or remedy the semiconductor shortage that has messed up supply chains.
Traders have brought forward expectations for rate hikes, fueling fears that central banks, including the Federal Reserve, will step on the brakes more aggressively than previously expected, risking an economic downturn.
High profile investors, including hedge fund titans Paul Tudor Jones and David Einhorn, have argued that Fed policymakers are more inflation creators than inflation fighters. And Jack Dorsey, CEO of Twitter Inc.
TWTR, + 0.32%
and Square Inc.
Sqm, + 2.20%
late Friday warned that “hyperinflation” was coming to the US and the global economy.
Major stock market indices continued to rise as inflation worries mounted. The S&P 500
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and Dow Jones Industrial Average
DJIA, + 0.34%
both ended on Monday at record highs, with the S&P 500 up more than 21% so far in 2021 and blue-chip value up nearly 17%.
Not a bond-friendly environment
How long will inflationary pressures last? Anyone making projections should do so with great humility, given the largely unprecedented nature of the post-pandemic restart, Boivin said upfront, saying it was reasonable to expect high inflation into the first half and perhaps into the second half of the year 2022 continues.
It is more important to understand the “nature” of the current rise in inflation than the time frame. Inflation is likely to stay well above target in 2022 and above target on average for the next five years, Boivin said.
This is not a bond-friendly environment for investors, he said, as the BlackRock Investment Institute favors inflation-linked securities over nominal bonds. However, it is not an “automatically” bad environment for stocks or other risk assets “which makes us underweight net-net government bonds but overweight global stocks” as investors see some inflation with a subdued political response.