The economy is in a midst of an economic slowdown with skyrocketing inflation. Global growth is expected to slump from 5.7% in 2021 to 2.9% in 2022 and hover around there in 2023-24. Markets have been spooked by negative customer sentiment and negative corporate earnings. Large economies like the US have experienced 2 quarters of negative GDP and smaller Emerging Market have defaulted on debt repayments.
The current conditions have brought on parallels with the 1970s, an infamous period of stagflation. But is this truly a valid comparison? To do so, we should look at each period separately.
First, are the current economic conditions. Central Banks around the world embarked on an unprecedented amount of monetary loosening and QE to boost demand during the Covid-19 pandemic, creating demand-side inflationary pressures. Compounding the damage from the pandemic, geopolitical tensions regarding Russia’s invasion of Ukraine, China’s dispute with the US on Taiwan, and China’s zero covid strategy magnified the slowdown of the global economy. China has reported contractionary PMI numbers below 50. Supply chain disruptions such as shortages of gas (Nord Stream 1 reduced to 20%) and food has propelled inflation further. Pressures from demand-pull and cost-push elevated prices to high single digits for most economies- far above their target range.
Alongside high inflation, the global economy slowed. Top and bottom-line corporate earnings missed expectations in Q2 as companies blamed the Russia-Ukraine war and supply chain issues. Amid lowered guidance, Q3 earnings in the US were more mixed. Companies with less price-sensitive clientele did not see a significant contraction in demand, while those with more price sensitive saw slowed demand.
With skyrocketing inflation, central banks globally embarked on steep interest rate hikes. The US has raised their base rate from 0.25-2.5% in a matter of 4 hikes- including two 75bps and possibly another one in August- to bring inflation down from 9.1% y/y as the FED quickly turned dovish to hawkish. Some central banks didn’t follow suit; the ECB only had one 50bps hike and the BoJ stuck to its ultra-easy monetary policy by keeping it at -0.1% to revive their prolonged deflationary economy. As CPI numbers were not subsiding and some fear for over hiking and unnecessarily bringing the global economy into a recession.
Despite all the bearish factors, the job market is still looking strong. In the US the unemployment rate reached pre-covid levels at 3.6% and job openings are at very high levels with a 7% opening rate relative to the labour force. However, there are hints that the hot labour market may be softening: rate hikes expect the unemployment rate to rise to 4.1% (conservatively) and June job opening rate data showed 6.6%- down from 7%.
As a result of interest rate hikes, persistent inflation, and slowing demand the following economic headwinds materialized:
-American equities entered a bear market (SPX down 23% from Dec21 ATH to Jun22 low) driven by top and bottom-line misses in corporate earnings, disappointing corporate guidance, and stymied economic growth. This was in line globally as the MSCI World index was down -21% YTD as of 30th Jun22. With VIX at lower levels than 2021, volatility further caused investors to shift to defensive portfolios by shifting into money markets. Hedge funds are heading for one of their worst years on record: According to HFR daily index, they were down 5.6% on average in the first 6 months of 2022 with losses mainly derived from long-short equity funds betting on changing equity prices.
-In the US Treasury Bond market, there was a 2 and 10-year treasury yield inversion- which has predicted the past 10 recessions- as the spread stands around -31bps as of Aug 2nd, 2022. Long-term yields pushed lower as the economic outlook stymied while Short-term yields pushed higher following interest rate hikes. EM Bonds suffered their worst start to the year since 1994 as JPM EMBI Global Diversified delivered total returns of 15% in 2022. This came after a sharp selloff amid risk-off sentiment from investors as well as strained public finances by the pandemic. Corporate Bond prices in the US sunk this year costing banks billions.
-For Forex markets, the dollar strengthening, though it is seeing a temporary pullback, by interest rate hikes has caused currency pairs to rise; it even reached parity with the Euro in mid-July. The strengthening weighted down on MNCs’ top lines as oversea sales fell. Further volatility in the Rouble was seen with the Ukraine invasion while the weakening of the JPY by sustained ultra-low monetary policy pushed the USDJPY pair to the upside.
In summary, all parts of the financial markets are facing headwinds. The main reasons are the combination of stymied economic growth and inflation: stagflation. Therefore, it makes sense why many make parallels with the great inflation in the 1970s.
The great inflation in the 1970s started in late 1972 to the early 1980s. When Nixon came into office, he ran budget deficits, supported income policy, and was a Keynesian economist. He took the stance of ‘taking inflation if necessary, but not taking unemployment.’ As a result of the pursuit of full employment (according to the Phillips curve lower unemployment will lead to higher inflation), the collapse of the Bretton Woods Agreement and going off the gold standard, and major spending in the Great Society legislation caused inflation. Uncontrollable factors also came into place as the Arab oil embargo quadrupled oil prices and the Vietnam war caused a fiscal strain. Because of these headwinds, from 1964- 1980, inflation skyrocketed from 1% to 14.5% and unemployment derailed from 5% to 7.5%.
At a superficial level, similarities between the 1970s and now are clear. Both commodities markets were disrupted by war, prices in the US were rising upwards of 8% y/y, both have seen the treasury yields invert, and fiscal and monetary policy was excessively expansionary.
However, the two have fundamental underlying differences. The 1970s had strong labour union power while trade unions have gotten weak over the years and people do not index incomes to inflation anymore; therefore, the wage-price spiral cannot be as vicious as it was before. Additionally, in the 1970s people were expecting inflation to continue accelerating while now people are expecting inflation to go back down. This mildly transitory expectation provides upside support during an economic downturn.
The 1970s as a case study can prove to provide further upsides. During the 1970s when economists were shocked that inflation and stymied economic growth can go hand in hand, Central Banks were lost- until the Volker shock. Now, Central banks are using the 1970s as a warning to front-load interest rates and make sure they are not behind the curve. As seen by the hawkish FED, there is a better chance central banks can tame inflation than in the 1970s. Of course, by frontloading interest rate hikes, a recession will be unavoidable (the US has already seen 2 negative quarters of GDP growth)- though is very unlikely for it to be as contractionary.
Additionally, new assets such as Cryptocurrencies and ESG funds have gained steam, changing the landscape of finance over the 50 years. This was exacerbated by the development of more complex financial assets from Reagan’s goal of deregulating markets. These risker assets bring volatility into the market at times of a risk-off sentiment- which could aggravate financial losses across all markets when compared to the 1970s.
Technological globalization and interdependence between nations are stronger than ever. As seen in the Russia-Ukraine war, regional conflicts can quickly become internationalized and financial markets can experience domino effects. The formation of the ECB, the strengthened IGOs like the World Trade Organization, NATO, UN, and IMF, and the interdependence of food/ raw material supplies have fostered liberalism across the globe. Henceforth, economies and financial markets have seen regional economic collapses grow into global crises and worsen the downside risks during a time of economic contraction when compared to the 1970s.
Lastly, after covid, we saw wealth inequality reduce by Covid relief and a tightening job market. A benefit of high inflation and the relatively strong job market is the increase in average nominal wages which comes with a higher rate of income increase in the lowest wage when compares to the highest quartile.
Overall, there are obvious connections to the 1970s, but the financial landscape has changed, labour unions have weakened, the FED is more equipped, and the job market is stronger. We may be better off returning to the policies we had in the 1990s where wages were growing faster at the low end and a larger fraction of adults had jobs. Hence, making it important for the FED to be nimble and balance between keeping a strong labour market while taming inflation. Replicating Volker’s policies of blindly hiking interest rates can have even graver consequences than it had in the 1980s. Credit card spending projected by BoA may be crucial to examining customer spending, and we must consider the 4-6 month lag of interest rate effect on the average person as if this is not considered, there will be increased personal debt defaults and collapse the financial system.