The risk of stagflation

A reader asks:

Is there a way to prepare for stagflation? Any actionable ideas?

Stagflation is an economic environment characterized by high inflation, high unemployment, and slow or negative economic growth. In other words, it’s not fun.

This is a risk that seems to be gaining traction among people who like to worry about things for a living.

larry summers (the boy from The social network) is one of those people who is constantly worrying about things. Here is his recent take:

The Fed’s current policy trajectory is likely to lead to stagflation, with unemployment and inflation averaging more than 5 percent in the next few years, and ultimately to a major recession.

There are a lot of people who think that the Federal Reserve is stuck right now. They may be right.

The Fed’s only option may be to curb demand by raising interest rates, signaling that they will do so at the expense of economic growth. It’s also true that inflation might not mind rising interest rates if supply chains remain tight and we end up with a persistent commodity crisis.

There is not much precedent for stagflation in the US.

The 1970s is basically the only period that comes to mind.

Let’s review what happened in the disco decade.

The rate of inflation was stubbornly high for most of the decade, averaging over 7% and rising to over 13% by the late 1970s:

The unemployment rate was also relatively high, reaching 9% after the 1973-1974 recession and ending the decade at 6%:

Real economic growth was probably better than most people assume at over 3%, but I’m not sure that would matter considering how much people hate high inflation:

The biggest difference between then and now is interest rates:

The 10-year Treasury yield was never below 5.3% in the 1970s. It averaged nearly 8% over that 10-year period and reached double-digit levels before the 1980s. The current rate of 2 .3% is nowhere near those levels.

The range in the fed funds rate in the 1970s shows how strange that decade was from an economic perspective:

Inflation was already rising in the 1960s, but a recession from 1969 to 1970 caused the Federal Reserve to raise short-term rates to almost 2%. That probably didn’t help with inflation. When rates rose to almost 18% in 1979, it was already out of control.

The simple answer to what worked in the markets in the 1970s is commodities.

The GSCI index increased more than 20% per year in the decade. Oil jumped more than 800%. Energy shares rose more than 70% on an inflation-adjusted basis. Gold was up nearly 1,000% overall.1

The US stock market as a whole performed better than you would think on a nominal basis. The ’70s are actually one of the best decades in terms of earnings growth:

This makes sense when you consider that corporations tend to raise prices in an inflationary environment.

The S&P 500 is up 78% overall or about 6% for the year. That’s not bad until you consider that inflation was up 7% a year, which means real returns were negative.

The most surprising performance from an asset class perspective might be how well cash did.

In fact, if we compare stocks, bonds, and cash dating back to the 1930sthe 1970s was the only decade in which cash beat both stocks and bonds at the same time:

This goes back to the history of rates, with much higher yields back then. You can also see those higher rates on bonds and cash during the 1980s, 1990s, and 2000s.

Value stocks had their biggest outperformance of growth stocks in the 1940s and 1970s:

The 1940s and 1970s also have the highest inflation rates of any decade since the 1930s.

Value stocks are already outperforming growth by a healthy pace so far in 2022. I don’t know if this relationship will hold, but it makes sense from a theoretical perspective that value would outpace growth when inflation is highest.

Changing economic environments are a good use case for my favorite risk management technique: diversification.

There is another asset that had its best nominal performance in the 1970s: housing. Here are Robert Shiller’s annual US housing returns by decade:

If you own a home, it’s likely to be your best-performing financial asset this year (especially when you adjust for the impact of inflation on your mortgage payment).

As with all economic outcomes, I don’t know if stagflation will occur. I can’t predict the future.

But the risk of stagflation appears elevated relative to where we were before the pandemic.

We talked about this question in this week’s Portfolio Rescue:

also had Taylor Hollis Please help me answer some questions about setting up trusts and donor-advised funds.

1Although it could be argued that a large part of the rise in gold prices in the 1970s was due to Nixon suspending the convertibility of gold to US dollars and allowing the price to float more freely.

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