Prices are climbing at the fastest pace in decades, leading to rising interest rates that have hit both stock and bond returns. A foreign war risks spilling over into a broader conflict, and an oil price spike threatens to exacerbate inflation and damage economic growth.
This describes the chaotic environment that investors have dealt with this year. It also describes the economies of the early 1970s and the early 1990s.
We typically associate the ’70s with high inflation. However, it wasn’t simply high inflation that made this period so painful. Instead, it was persistently high inflation that coincided with slow to declining economic growth, hence the term “stagflation.”
The early ’90s also saw an economy struggling with rising inflation and slowing economic growth. Economists blamed the recession of ’90 – ’91 on pessimistic consumers, elevated oil prices, and attempts by the Federal Reserve to lower inflation, all of which should sound familiar to us today. However, following the recession, annual inflation remained at approximately 3% or below for the remainder of the decade.
While recent data has increased the risk of the return of stagflation, there are still reasons to believe that a return to the ’70s is not a foregone conclusion, and the economy could follow a path more closely resembling the early ’90s or at least a path somewhere between the experience of the two decades.
The events and policy decisions over the remainder of this year will determine which period of history will serve as a better parallel going forward.
Specifically, the two most important questions this year are (1) When will inflation peak? and (2) How likely is a recession?
When will inflation peak?
While there is data that indicates we may be approaching the peak of inflation, rising energy costs and rising prices in service categories such as rent signal that elevated inflation is persistent and will be challenging for the Fed to bring lower.
The chart below shows the breakdown of May’s inflation data. We have seen prices start to decline for goods that drove the initial spike in inflation, but services such as rent make up a more significant proportion of the inflation index. Additionally, energy has become a major contributor to rising inflation and will likely require policy changes to bring prices back to more tolerable levels.
Source: Bureau of Labor Statistics
One of the most reliable predictors of future inflation is wages. Current wage growth would forecast a long-term inflation rate of ~5%, which would represent a reduction in the current headline rate but is still significantly above the Fed’s target of 2%.
One of the Fed’s primary concerns is the risk of a wage-price spiral. This happens when wages and prices become locked in a self-reinforcing loop, causing each to continue rising higher. For now, although wages are rising faster than the Fed’s 2% inflation target, it does not appear that we have entered a wage-price spiral. However, this risk increases the longer that high inflation persists.
Source: Federal Reserve Bank of St. Louis
How likely is a recession?
The odds of a recession increased significantly after the Federal Reserve raised interest rates by 0.75% last week. The tightening of financial conditions is already having an impact on the economy, particularly in the mortgage market. Moreover, in their press conference, the Fed made it clear that they are willing to put the economy in a recession in order to reduce inflation.
The good news is that overall, households are financially healthy, and a recession would likely be mild to moderate rather than a repeat of 2008. In ’08, households were over-leveraged, and the resulting recovery was slow as consumers had to rebuild their balance sheets before they were able to start spending again.
Economists estimate that US households started the year with ~$2.4 trillion in excess savings. These savings came from reduced consumption during the pandemic but also a massive increase in personal income, driven by government stimulus. Brian Moynihan, CEO of Bank of America, recently said on an earnings call that households that held an average balance of $1k – $2k pre-COVID now have an average balance of $4k, and households that held an average balance of $2k – $5k pre-COVID, now have an average balance of $13k. This represents a significant buffer for consumers.
Retail sales declined slightly in May, but they are still growing faster than trend. This will be important to watch closely since consumer spending represents roughly 68% of the US economy. If consumer spending remains strong, it may help the US avoid a recession or at least reduce the severity.
Lastly, while a recession could mean further downside for equities, a mild recession in the near term could help reduce inflation and the risk of a more severe downturn in the future. Fundamentally, recessions are an important part of capitalism and serve the role of cleaning up pockets of excess in the economy.
May’s inflation print certainly makes the Fed’s goal of a “soft-landing” for the economy appear even less likely than before. However, for now, the data indicates that a bumpy landing is more likely than a crash, and a return to the stagflation of the ’70s is not unavoidable.
It is worth remembering that the US economy is very different than it was in the ’70s. While still important, our economy is much less reliant on oil. Also, thanks to the shale revolution, the US is the largest producer of oil and gas in the world. The global oil market faces a serious supply and demand imbalance, but the US has the ability to make significant improvements in that imbalance with the appropriate policy actions.
Lastly, the most important lesson in investing is to maintain a long-time horizon. If you invested in the S&P 500 twenty years ago and missed the first ten days of each market rebound, you would have missed out on more than half of the market’s gains. Additionally, lower valuations and rising yields have increased long-term return expectations for stocks and bonds. Going back to the early 1930s, there have been four years where a 60% / 40% stock / bond portfolio experienced double-digit declines. In three out of four of those cases, the next twelve months saw positive double-digit returns, and in every case, the portfolio gained over 20% over the next two years.