Investing during an era of stagflation - a cultural guide.
One of the joys of re-watching old films is spotting the cultural assumptions of the time which you missed when you first watched it. Daniel Craig’s first outing as Bond in Casino Royal saw an opening fight sequence to the backdrop of a construction site, an African war lord trying to invest his ill-gotten gains with ‘no risk in the portfolio’, and the baddy Le Chiffre buying put options on the stock of aeroplane manufacturer Skyfleet. A super film to the backdrop of super-financialisation - how very 2006.
The global economy may be entering an era of stagflation, characterised by low or even negative economic growth, elevated unemployment yet with stubbornly high inflation. This ugly cocktail seemed to have been consigned to the dustbin of history along with flairs and platform shoes, but a combination of Covid-related supply shocks, massive government deficit financing from the pandemic, along with serial under-investment in the energy and commodity space in part driven by the politics of climate change and now the disruptions of war have put stagflation back in the limelight.
What was the stagflation experience of the 1970s actually like? In his book ‘The Last Stone’, an account of the extraordinary interrogation of Lloyd Welch in the Sheila and Kate Lyon murder case in the US, author Mark Bowden sets the backdrop to the crime in question with a vivid description of 1970s America:
“Ground was shifting under enduring institutions of American life, and the promise that had propelled the country so dynamically through the 1950s and 1960s had soured. Jobs were scarce, and paychecks didn’t go so far – a phenomenon dubbed “stagflation”. Americans had stopped buying stocks – they were no longer betting on the future.”1
Imagine a situation so grim that Americans stopped buying stocks. Joking aside, one gets the sense that hope had disappeared and life had become a day-to-day struggle to put food on the table. The cost of living was already rising before the Ukraine war, but the direct disruptions in food supply-chains this has caused, along with the secondary effects of higher gas prices on fertilizers and related materials, will likely make their unpleasant effects felt on consumer prices as 2022 progresses. Food shortages are a real prospect for the developing world, along with all the disorder that normally accompanies them.
Having fluffed their lines on transitory inflation in 2021, the US Federal Reserve is now pushing a ‘soft landing’ narrative. The hope is that raising interest rates will curb demand in the economy while a white-hot job market will mean an economic hard-landing (recession) will be avoided. This sort of thinking allows one to brush aside the -1.4% US GDP print in Q1 2022 and to ignore plummeting consumer confidence, a slowing in the housing market and a series of other economic indicators (not least China’s economic troubles) which suggest there is a problem under the hood already.
While recessions are a ‘great way’ to curb inflation, it seems unlikely that the Fed can repeat the heroics of Paul Volcker in the early 1980s when as Fed Chair his ferocious rate-hiking turned the tide of inflation expectations at the cost of repeated recessions. As Richard Bernstein points out in the Financial Times (‘You are what your real fed funds rate says you are’, 10/05/2022, FT link), Volcker got real rates (the target Fed funds rate less inflation) up to 10%, while the current inflation-adjusted rate is still negative 7.5%. Yet even now, financial markets are swooning.
The difference between the Volcker era and now is that the global stock of debt, much of it in dollars, is considerably higher. While the Fed can talk tough, we know from recent experience that when rate hikes cause financial conditions to tighten such that the credit market closes (as happened in late 2018), the Fed has to do an about-face, since an inability to roll over debt would likely cause a swift and substantial economic collapse. This is true even without considering what difficulties a higher rate environment will cause the US government in funding a large primary deficit while tax receipts fall as the economy slows.
There is a sense that central banks, particularly the Fed, will carry on doing their thing until something breaks, either in the economy or the financial markets. When that happens, not only will there be an interest-rate policy reversal, but if there is a pronounced economic slowdown, then the political pressure for fiscal accommodation will be almost unstoppable, notwithstanding the uncertainty about the outcome of the US mid-term elections in November.
Either way, and particularly since the underlying causes of the supply-side issues (war, under-investment in energy and commodity production, China’s zero-covid policy amongst others) won’t have been fixed, elevated inflation seems to be here to stay. This is true even if we have reached a short term peak in the actual CPI and PPI prints we see around the world in the next few months.
When it comes to economics, markets and popular culture, there has to be a zeitgeist of some sort to get Hollywood to put such a dour topic on the big screen. After the global financial crisis, we saw films such as Margin Call (2011) and The Big Short (2015) about naughty bankers and the subprime crisis. In 1983, the big finance film was Trading Places, ostensibly retelling the story of the Hunt brothers’ silver squeeze but this time set in a commodity brokerage in Philadelphia.
Once required viewing for all new-starters on trading floors around the world, the important point is that while Casino Royal was all about put options and property, Trading Places was all about commodities, and it was the rise in commodity prices during the stagflationary 1970s that made the backdrop of the film one to which the audience could relate. It seems real assets, including commodities, are the prime movers during stagflation.
What of equities during periods of high inflation and low growth? Consider the poor performance of growth stocks in the Nasdaq this year in the light of the extended quotation below from Warren Buffett’s 1979 Berkshire Hathaway annual shareholder letter:
“But before we drown in a sea of self-congratulation, a further - and crucial - observation must be made. A few years ago a business whose per share net worth compounded at 20% annually would have guaranteed its owners a highly successful real investment return. Now such an outcome seems less certain. For the inflation rate, coupled with individual taxes, will be the ultimate determinant as to whether our internal operating performance produces successful investment results.
“..if we should continue to achieve a 20% compounded gain…your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.
“..That combination…can be thought of as an ‘investor misery index’…We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”
Not exactly upbeat stuff, but very little needs adding to this analysis. It seems unlikely that inflation will get to 14% in the foreseeable future, but the problem of generating a positive return on equity to the backdrop of high inflation and low growth remains the same.
It’s worth noting that at the most recent Berkshire Hathaway annual meeting, Mr Buffett revealed a five-fold increase in his investment in US oil major Chevron (ticker CVX). Not exactly a win for climate-change campaigners, but given the discussion above about commodities and real assets in a period of inflation (or possibly stagflation), one can at least see how the sage of Omaha is thinking.
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‘The Last Stone’, Mark Bowden, Grove Atlantic (2019).