Stagflation is the buzzword in recent times. The definition of stagflation will be persistent high inflation combined with high unemployment and stagnant growth in a country’s economy.
The most relatable period in which we can have insights into the impact of stagflation would be a relook into the 1960s-1970s period. This was the only time since modern history(20th and 21st century) that this economic phenomenon has happened.
Inflation was persistently above the 8% mark throughout the period from 1972 to 1981.
History Rhymes
As Mark Twain famously quoted:
“History does not repeat itself but it certainly rhymes”
There are many market analysts and commentators that dismissed the possibility of stagflation happening and argue that the situation is different this time. One of the main arguments is that stagflation is caused by the oil shock in the 1970s which send oil prices spiralling up and the US was heavily dependent on it.
Currently, the US is a net exporter of oil as they have the largest shale oil reserve in the world and with the advent of alternatives (Solar, Wind and Nuclear), the impact of oil on the economy would be less pronounced.
But we might not have an oil shock but a debt shock could be on the cards which have been built up from trigger happy Quantitative Easing in the past. Debt to GDP is at a record of 124% versus 35% in the 1970s.
The increase in interest rates will increase the burden of servicing the debt. With inflationary pressures, the money printing press has to be prudent so as not to affect the credibility and standing of the US Dollar. This would restrict stimulus packages.
The US could just inflate their way out of trouble by keep printing money and retiring the debt and interest that comes due. This would likely lead to financial chaos as the US dollars would depreciate and even be devalued as fewer people would be confident of holding US dollars.
Taking this argument aside, we do see uncanny similarities between this current period and the 1960s-1970s.
Singapore’s well regarded Senior Minister, Mr Tharman Shanmugaratnam, have also recently highlighted that the current environment could exceed the infamous stagflation of the 1970s.
Let’s Go Back Memory Lane
It is the roaring 1960s and the growth/ momentum stocks are eking out great returns. The monetary policy started to slant towards over easing in the mid-1960s which was a conducive environment for growth stocks as liquidity is high.
Gerald Tsai (Equivalent to Cathie Woods) would be the prominent poster boy for this era where his Fidelity Capital Fund- Aggressive Growth Fund- launched in 1958 managed to generate a return of 296% up till 1965 trouncing his peers by a fold. He has invested in glamour or what they deem as go-go stocks such as Xerox and Polaroid with concentrated holdings.
Cathie has done better with a 650% return from Ark Innovation Fund launched in October 2014 to their peak in Feb 2021 over 6.5 years.
Tsai started his own flagship fund- Manhatten Fund- in 1965. It started strong with a first-year 39% return but eventually faltered with the fund down by almost 90% during the 1969-1970 go-go stocks crash. Those who want to delve further into the era of the go-go stock could check out this book.
Warren Buffet closed his fund in 1969 near the top before the crash, his timing has been impeccable. When Tsai resigned from the fund in 1973, the fund was down 70%.
The US was also fully engaged in the Vietnam War from 1965-to 1973. At its peak, there were 500,000 US Troops stationed in Vietnam. The war claimed 58,000 casualties on the US front. We currently have the Russian and Ukraine war which the US is not keen to commit troops but we have to see how it pans out.
With the crash of the go-go stocks, the S&P went in tandem as it corrected 30% but they eventually started recovering as funds flow to the nifty fifty- the bluest chip and best quality companies- driving prices up to PE of 50-100 for most of them.
S&P 500 also hit new highs during this surge. Coca Cola was trading at a PE of 40 in 1972 and in 1981, they are trading at a PE of just 9.
Eventually, Newton Law sets in, and many of these Nifty Fifty stocks plunge by close to 80% to reflect reality. S&P was down from the peak by 40%. Not factoring in inflation, the S&P high in 1969 was only surpassed convincingly in 1980, and so you could term it as a lost decade.
The market was basically trading range-bound throughout.
The reasons for the last surge in 1972 could be due to President Nixon’s fiscal policies announced in August 1971 when he was seeking re-election, he wanted to boost growth without triggering inflation that was at 5.8%.
These are the 3 policies he proposed then and this is the video of his announcement.
- 90 days freeze of wages and price which is meant to tamper inflation
- 10% import tariff to protect domestic industry
- End of Dollar Peg to Gold which will give flexibility to their monetary policies
The initial response saw enormous approval as it sends a signal that the administration is having a good grasp of the inflationary situation. However, with the wages and price control, businesses are not able to keep their competitiveness and were not able to be profitable- they were not able to raise prices nor reduce wages. The import tariff creates further pressure to inflationary pressure as imports are now more expensive.
The Current Environment
Doing a comparison, we could possibly be in 1970 as innovation and glamour stocks have fallen by close to 70%-80%. The S&P 500 is down 13% from its peak.
There could be a further weakness of the S&P 500 going forward. After which, we could potentially see a rotation of funds to the strongest, best quality companies and the value stocks for the last burst of this bull market if the 1970s unfolds again. The smart money has to flow somewhere.
| Stock | Price Earnings Ratio | Price to Book | Return on Investment |
| Apple | 26 | 35 | 44% |
| Amazon | 45 | 10 | 14% |
| Meta | 14 | 4 | 27% |
| Microsoft | 30 | 15 | 25% |
| Berkshire | 8 | 1.43 | 11% |
Source: Reuters
Taking a look at the table, the nifty fifty of today is not trading at excess valuation– we did an analysis on Meta–Â and thus there could be further upside. However, this could be the final 10 minutes of the soccer game. Moreover, despite the inflationary threat, unemployment in the US is at 3.8% compared to 1971 at 6.1%.
The buy on dip strategy did not work well this round as money printing is off the table with inflation hitting 8% at the latest reading. Previously, inflation was never a big issue and it was well contained below 3%.
With excess liquidity taken out, the appetite to punt on glamour/concept stocks dissipates. The funds would be highly selective in their investment decisions.
What Sectors will do well in Stagflation?
Source: Schroders
With stagflation possibly around the corner, how should we position our investment portfolio?
Looking at the analysis of Schroders on past returns of different sectors at the different stages of the business cycle gives us great insights.
It was evident that Gold and Commodities will do well in this environment and prices have already spiralled up for commodities. As for gold and silver, it is coming off the consolidation base and look poised to break new highs.
Source: MooMoo- Farmland Partners REIT chart
In a stagflation environment, you would be looking to preserve your capital from runaway inflation by investing in real assets such as property, gold, commodities and etc. Even farmland have seen great returns recently based on the prices of farmland REITs.
REITs would give decent returns based on the analysis but we opined that as we are just at the start of the interest rate hiking cycle, therefore we could hold back first for the price to adjust to the effect of the rate hike.
If the interest rate goes to around 4%-5%, we feel Reits would still be able to withstand and adapt but anything above would greatly affect their ability to service their loans.
In 1981, US mortgage rates went up to almost 20% which was a convicted and decisive policy move to tame the inflation giant then.
Equities and bonds would go through tough times during this period as whatever profits a company makes could be eroded by the effect of sky-high inflation. Bonds naturally do not do well in an interest rate hiking environment but exposure to short duration bonds could be an avenue to consider if we are looking into bonds.
Summing Up
Stagflation seems to be around the corner with current conditions showing an uncanny resemblance to the 1970s period where stagflation was the theme.
If the 1970s playbook unfolds, we could still see the last surge for the strongest and best quality companies which is not excessively valued before the market fizzles off.
In a stagflation environment, the market would likely just consolidate and trade range-bound which would lead to a lost decade just like the 1968-1981 period. Due to the high inflation, there will be negative real returns.
The main goal for investing during this period is to preserve your capital and so investment in real assets such as property, gold, commodities and REITS have historically performed relatively well during this stage of the business cycle.
Crazy returns of the Ark funds era could be a thing of the past as funds would be very selective and would go for companies that actually generate profits, cash flow and not just a good concept. This is especially so as a tighter monetary policy would be the norm in this environment and liquidity would not be in excess.
It is going to be a tough time to navigate the investment landscape if stagflation does occur. We hope a revisit to the 1970s helps you to come up with a game plan.
Disclaimer:
The content here is for informational purposes only and should NOT be taken as legal, business, tax, or investment advice. It does NOT constitute an offer or solicitation to purchase any investment or a recommendation to buy or sell a security. The content is not directed to any investor or potential investor and may not be used to evaluate or make any investment. Do note that this is not financial advice. If you are in doubt as to the action you should take, please consult your stockbroker or financial advisor.
