Among all dreadful economic phenomena, stagflation seems to strike the most terror in investors. Interests in stagnant inflation have begun to grow – according to Google Trends, searches for “stagflation” in the second week of October surged fourfold than in the past five years on average.
Stagflation refers to a combination of high unemployment, high inflation and low growth. If the central bank cuts interest rates in response to high unemployment and low growth, it will likely push the already elevated inflation rates even higher; but if it is reining in inflation that the central bank aims to achieve, raising interest rates will lift the unemployment rate even higher. In other words, stagflation puts the central bank in a sticky territory in planning where future monetary policies are headed.
Similarly, stagflation spells trouble for investors: In the early 1970s when the US was hit by stagflation, the S&P 500’s P/E ratio was around 18x, but by the end of the same decade it plunged to just over 7x. Stagflation clearly does anything but benefits stock market valuations.
Investors curious to find out whether the current global economy will fall into stagflation would do well to understand what caused it in the US in the 1970s. Granted, no two economic trajectories from different periods look the same, but the past might just tell us a thing or two about the present. We hope the analysis ahead will help investors trace the contours of the previous stagflation period.
Although stagflation struck the US in the 1970s, it was in fact a long time coming, dating back to the decade before that. At that time, President Johnson rolled out aggressive fiscal policies, including tax cuts and hefty government spending to promote his “Great Society” plan. Moreover, at the height of the Vietnam War, the US had an army of 540,000 deployed to the country, which amounted to large military expenditures, in turn stimulating the US’s economy. In the hope that President Johnson would raise tax rates to cushion the impact the fiscal deficit had on the economy, Then Fed Chair Martin sat on his hands, when he should have raised interest rates. What resulted from such a policy slip were obstacles to the extent and timing of interest rate hikes.
While President Johnson’s policies introduced inflation, it morphed into stagflation under President Nixon’s.
Between August 1971 and mid-January 1973, in a bid to get re-elected, President Nixon opted for administrative measures in implementing price controls to reduce inflationary pressures, thereby increasing his chances in the election. Nixon did end up serving a second term, but price controls fell flat in suppressing inflation; rather, inflation ran higher as strict price controls reduced suppliers’ incentives to boost supply.
At the same time, President Nixon moved to sever the link between the US dollar and gold. The move came against a backdrop completely different from what we now know as the global monetary system – most Western countries’ currencies then were pegged to the US dollar, which was then pegged to gold, while allowing these countries to have their US dollars converted into gold at a fixed rate at any time. In the post-war period, the US dollar became an international currency, which translated to huge circulation abroad that overwhelmed the US government’s gold reserve under such currency exchange requirements. At that time, when these countries needed to have their US dollars exchanged into gold, the government had two options – depreciate the dollar or raise interest rates. But given President Nixon’s concern that interest rate hikes would hamper the economy, he had no choice but to decouple the dollar from the gold standard system, resulting in a weaker dollar that also worsened the effect of imported inflation on the economy.
Unfortunate events, unfortunately, almost always come after another. In a war that broke out between Israel and neighboring Middle Eastern countries in October 1973, the US’s support for the former attracted criticism from oil exporting countries in the region. In addition to pre-existing frustrations that arose from a decline in income among oil-producing countries due to a weaker dollar, the US’s siding with Israel became the last straw that drew retaliation from disgruntled Middle East countries, which moved in unison and imposed an oil embargo against Western countries, leading oil prices to shoot up. What resulted from the ordeal were shrunken Western economies, elevated inflation rates, and the official beginning of the stagflation period.
Moreover, Arthur Burns, then chairman of the Federal Reserve, had relatively weak political backing and wavering monetary policy stances. Upon rounds of back-and-forth between stimulating the economy and suppressing inflation, Burns never managed to achieve either, which also caused the public to lose confidence in the central bank.
Are recent rises in energy prices signaling the beginning of stagflation?
For the time being, we think the current state of play resembles that of the late 1960s more than the 1970s, so whether stagflation will actually set in is yet to be known. The stagflation period in the 1970s stemmed partly from government policy blunders, and partly from the global political and economic environment at the time. Having said that, we believe central banks and governments across various regions still have the capacity and time to keep stagflation at bay.
Firstly, most people are still fairly confident in the Fed’s objective to stabilise inflation growth at 2%. But if inflation continues to hover at 4% in the next two years without any interference from the Fed, whether market consensus would still see a 2% inflation growth as a reasonable target could become a concern for investors.
Moreover, given that the current rising inflation comes partly from the pandemic-induced supply bottlenecks and a surge in demand that the global governments’ extremely loose monetary and fiscal policies have created; as authorities gradually dial back most of the stimulus, and that vaccination rates climb steadily, supply chain issues are expected to be resolved over the coming year, thereby restoring the balance in supply and demand.
Thirdly, the existing energy shortages are partly a result of climate anomalies this year, such as heavy rains in coal-producing areas in Indonesia, India, and China, and unusually light winds in the North Sea in Europe. Given that the climate typically changes from time to time, supply levels will likely increase as it stabilises.
Finally, provided that no price control measure will be implemented, higher prices will attract new investment and suppress demand. With additional investment capacity entering the market, increasing supply levels, we should see inflationary pressures start to ease.
 Source: Google Trend, as of Oct 2021
 Source: multpl.com, as of Oct 2021
 Source: Wikipedia, as of Oct 2021
 Source: Federal Reserve Bank of Minneapolis Quarterly Review, as of Oct 2021
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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