Stagflation: Investors’ worst nightmare yet?

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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[1].

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[2]. 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[3]. 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[4].

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.

[1] Source: Google Trend, as of Oct 2021

[2] Source: multpl.com, as of Oct 2021

[3] Source: Wikipedia, as of Oct 2021

[4] Source: Federal Reserve Bank of Minneapolis Quarterly Review, as of Oct 2021

Disclaimer

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.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

Stock-picking Strategies: Why good C-Suites matter?

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The worst nightmare of any worker is perhaps having a horrible boss: ａspineless one does nothing to drive growth in the company, or in its employees’ salaries; equally, an egotistical one is no better if he feels he is too good for any advice coming from his subordinates.

As for investors over the course of stock picking, much like all company workers, we think identifying the right CEO is just as important as putting the capital in the right industry. Granted, even the greatest CEO will find his hands tied in an industry subject to a particularly difficult operating environment, which diminishes the effect of whatever business strategies that have been put into place. The global banking industry, for example, has not only been under much tighter supervision since the 2008 financial turmoil, it has also struggled with ultra-low interest rates, which put a dent in their profitability. Under such circumstances, these institutions’ heads could probably do no more than ease the hardship their companies have been confronting with.

But in the tech field, the differences between good and horrible bosses are much more pronounced. The reason being, with the rapid advent of technologies, just a couple of slip-ups will cost a company years for it to be able to catch up with its competitors again. Intel’s Brian Krzanich, a.k.a. BK, is perhaps one of the most relevant examples.

In the high-tech space, the upside to being a larger player is that, the more profit it makes, the better placed it is to allocate more resources to research and development, and explore new product lines and technologies, thereby maintaining its leading edge, while making it difficult for successors to catch up. This explains why Intel was – for a long time – the leader in the semiconductor industry, where it once commanded the largest market capitalization. But its lead in the semiconductor space was overtaken last year and the year before that, once by Nvidia and again by TSMC respectively[1]. So, how did Intel lose its grip on semiconductor production? What lessons can investors learn from its descent?

Some attribute Intel’s pain points to its IDM business model. IDM, Integrated Device Manufacturer, is a business model in which a company straddles both semiconductor design and manufacturing. Intel operates differently from its peers in this respect. TSMC, for example, only makes chips without being involved in designing them. But such an argument can hardly explain why, just a few years ago, Intel’s scale and manufacturing technology were still ahead of TSMC. If it had been an issue with its business model, Intel would have lost to the Taiwanese company long ago.

The crux of the issue might have been its CEO.

The biggest challenge for semiconductor foundries is keeping the production yield high throughout the entire manufacturing process, which can easily run to hundreds of steps. Even if that of each step reaches 99.9%, half of the overall output may still turn out to be defective. Only when 99.99% of the units coming out of each step pass relevant quality checks, can we consider the production line efficient. But given that the crystals in a chip may just be a few nanometers apart – amounting to just one ten-thousandth of the width of a human hair – the efforts it requires to sustain a high production yield in each ultra-high-precision step are simply unimaginable.

Hence every single employee in the entire company must ensure seamless collaboration to make this goal a reality: resources have to be directed to where an issue arises, immediately. In Intel’s case, former employees have spoken of BK as being egotistical, and his management style tyrannical. He was said to dislike communicating with employees, in addition to having the habit of humiliating them in public. He was also said to have turned a blind eye to warnings from his employees that there might have been issues with Intel’s 10-nanometer production, which led to his failure in deploying a timely solution. A sense of being underappreciated also led to an exodus of staff members in Intel. BK had to step down eventually in 2018, with the position succeeded by Intel’s Chief Financial Officer, Bob Swan.

As a company welcomes its new CEO, it’ll also likely herald a turning point in its performance. For example, under the reign of Steven Ballmer, Microsoft’s stock price had stood strong for many years, but since the appointment of Satya Nadella in 2014, its share price has risen sevenfold[2]. At the beginning of this year, Intel brought on board company veteran Patrick Gelsinger, a.k.a. PG, as CEO. Having been with Intel for three decades, doubtless PG knows its success story like the back of his hand; but what is yet to be known is whether he will steer Intel back on track to see its heyday again.

[1] Source: Companiesmarketcap.com, as of Oct 2021

[2] Source: Google Finance, as of Oct 2021

Disclaimer

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.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.