August 2021

In our second inflation note, we look at a scenario, that while far fetched, remains the single most visible downside risk to multi-asset portfolios over the next decade.

The scenario to which we refer is a 1970s style stagflation episode. We look at asset class returns through the 1970s, which were especially tough for asset allocators, and hold important lessons for multi-asset investors today.

As the developed world entered the 1970s, it had done so on the back of record low unemployment, low interest rates, surging consumer demand, and healthy GDP growth.
What derailed this near perfect economic environment?

A confluence of geopolitical, financial, and structural factors turned what should have been a fantastic decade for investors into a volatile, difficult, and turbulent one.
In some ways the world we enter in the second half of 2021 has parallels with 1973, which makes us wary.

The first parallel is the pick up in commodity prices, as per the 1 year percent change in the chart below:

The 1970s started the decade with low interest rates, both on a short and long term basis, as per the chart below:

The parallels do not end there.

At the start of the decade, GDP growth had been healthy, peaking at 7.6% as late as Q1 1973. In December 2020, the US federal Reserve was forecasting 5.5% for the calendar year.

Again we are not suggesting this is our base case; we are far more optimistic than that. We are however in uncharted waters in many respects in 2021, and the risks of stagflation are real.

Indeed, the early period of a structural inflation episode can feel a lot like a raging bull market. As inflation expectations rise, consumers bring forward purchases, fueling demand in the short term and driving up company revenues and prices for goods and services.

This mania can take hold on the back of an environment of surging demand and contracting supply, and it feeds on itself to an extent.

It is mainly this vicious circle which in our view is the key to understanding inflation dynamics, and is as much a behavioural phenomenon as one driven by regulated wage rises and other economic inefficiencies.

The 1970s stagflation was only broken successfully at the start of the next decade, with a painful rise in interest rates to 14% and an associated recession.

Was there anywhere to hide for investors?

It was in many ways a painful decade for listed investors.

Australian Equities ended up the only asset class outperforming inflation, with the gains being made at the very tail end of the decade, as a commodities (particularly gold) rally gripped the equity market.

Above figure: asset class returns through the 1970s, sources Refinitiv Datastream, RBA, *Resonant calculations