There’s considerable debate around whether developed countries are headed for a high inflation regime.
The obvious real-world concern is that such an environment, if not paired with robust growth, would be disastrous for households and “regular” people.
In a world where inequality in advanced economies is approaching Belle Époque extremes (figure below), surging prices for necessities and everyday goods and services could lead to social unrest. In “America’s Economic Divide In Two Stories,” I wrote that,
The circumstances of an average person just trying to make it in America and life as experienced by the affluent, are now so divergent that it’s difficult to see how the two economic classes can possibly communicate with one another, let alone commingle or otherwise interact in ways conducive to civic order.
In the very next breath, I was less euphemistic. “This will end in some manner of social breakdown,” I suggested. “America got a preview of this film in the summer of 2020. Expect the full-length feature to be far more dramatic.” (What can I say? Weekends are for melodrama.)
If some iteration of the societal breakdown thesis were to play out, it might not matter all that much what happens to financial assets. I have to strike a balance between lively, engaging socioeconomic commentary and comparatively dry market-focused content. The former is “the brand,” so to speak, but the latter is necessary and indispensable.
When it comes to markets (i.e., leaving aside the more important socioeconomic story), one concern is the dearth of investors and traders with experience operating in a stagflationary environment.
Another, related, worry is that between i) the four-decade bond bull, ii) the so-called “Great Moderation,” iii) the assumption of a negative stock-bond return correlation, iv) massive amounts of embedded duration across assets and v) the fact that many models were calibrated during a prolonged low-vol regime, a seismic shift (a new epoch) could be highly destabilizing to the extent it crumbles the entire edifice.
There are no easy answers to the myriad questions implicit in the above. Given the ambiguity and, perhaps just as importantly, the distinct possibility that it all turns out to be a false alarm, we’re left with few options other than to recount the 70s in America in the (possibly misplaced) hope that past is precedent — that a sample size of “1” can help when it comes to knowing what we should do assuming the onset of an inflationary regime and no concurrent societal breakdown that renders discussions about portfolio rotations secondary to more pressing concerns about paupers with pitchforks.
If the past is a useful guide, then successfully trading stagflation (and there’s no guarantee that inflation which sticks around for a while would beget stagflation, but that’s the narrative du jour) will entail understanding what BofA’s Michael Hartnett calls “three historic phases of the Great Inflation.” Those phases are “The Birth,” “The Reality” and the “The Shock.”
“The Birth” lasted for three years, from 1965 to 1968, when “the post-WW2 period of very low and stable inflation and rates ended driven by Great Society spending, Vietnam, civil rights, unionization [and an] acquiescent Fed,” Hartnett said, noting that “as inflation became unanchored in late-60s government bond and credit returns [were] poor but the ‘barbell’ of small-cap value and Nifty 50 tech performed very well.”
Hartnett then described “The Reality,” which lasted for four years to 1973, as a period when “inflation and rates moved to new highs as the end of Gold Standard/Bretton Woods, failure of price and wage controls [and a] too-easy Fed caused inflation expectations to become entrenched.” You wanted commodities and “particularly gold,” he remarked, noting that “in real terms, stocks and bonds underperformed while volatility ripped.”
Finally, “The Shock” (1974-79) found investors staring down “oil price shocks, power shortages, food price shocks, labor unrest, wage price spirals [and] major budgetary pressures,” Hartnett wrote, adding that with the global economy still in re-opening mode, “this type of stagflation” is “unlikely” given that it “arrives once inflation cause[s] lower spending and higher savings.” Still, caution is warranted given that inflation is likely to “remain high in 2022 and beyond driven by wages, rents, climate change and possibly the Fed turning significantly more ‘progressive’.”
If you’re wondering what a more “progressive” Fed would look like, Hartnett suggested monetary policy might “shift from targeting Wall Street inflation to Main Street inflation,” which would “ultimately [be] very US dollar bearish.”
There’s an inherent tension in this type of analysis. Implicit is the notion that inequality, “Wall Street > Main Street” and a Fed that perpetuates the wealth divide are suboptimal outcomes. But even more forceful (albeit also implicit) is the idea that overt policy shifts aimed at reversing the situation could be disastrous.
To the extent that tension is, in fact, present, you can write it off to the necessity of saying the “right” thing at a delicate juncture while being careful to avoid advocating for the type of change that would destabilize a system which benefits the people analyzing it from the top of the social pyramid.
Ironically, the cure to stagflation in the ’70s was the shock of higher interest rates engineered by the Volker-led Fed. Ripping the band-aid off, if you will. Now, in part due to the fecklessness of corrupt, long-serving members of Congress and key regulatory agencies, the leverage in the system today is much, much greater — as would be the pain associated with rapid band-aid removal. But as all athletes know, no pain, no gain. If we want to avoid the kind of socioeconomic crisis you allude to, we’re going to have to deal with some pain.
I have seen accounts of Europe after a bout of the bubonic plague. That experience may be somewhat more germane to our experience than the 70s stagflation. In the account of the economy, historians recounted how wages took a jump since the labor force available to landowners particularly had dropped. Now of course there are major differences now too. For one, we are not agrarian and can substitute capital for labor to some extent much more than in 1300s. Also the labor force is more mobile both for immigration and working remotely. Some workers are getting sick and dying in our situation, more commonly some are leaving the labor force due to early retirement or long covid- in the 1300s they just died. So society is going to be handed a bill for long covid. This is my long winded way of saying we may get a one time wage increase combined with a one time increase in labor productivity as capital is substituted for labor in some jobs. It does not necessarily portend a long run increase in inflation once the economy adjusts to the new level.
Reading your comment I was struck by the transition in labor mobility that has arisen because of the many new tools for remote work that have been developed in the last couple of years. People don’t just work remotely for their local employer any longer. Instead, many work from sites several states away. My daughter’s boss is in New Jersey while his direct reports are mostly in KC. One of her best friends lives in suburban KC and works for an employer in Oregon. Many folks have found they can be mobile and effective without having to move. “Regular” blue-collar and minimum wage folks mostly don’t enjoy this luxury but a great many white-collar professionals can be fully mobile without moving. Thanks for your insight.
Per Warren Buffett in 2006: “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.”
Quote from a female Trump supporter that just scrolled by on a news channel: “I see a civil war coming…”
Some people saw this war coming before others, hence the militarization of the police during preceding decades. That tells me that the winners of the class war intend to hold onto their winnings with whatever force is necessary.
I wonder how long the Republicans will be able to control the mob they have gathered and the value of the ashes of Buffett’s holdings in the future.
Are you suggesting that there are a lot of American patriots out there who are getting sick and tired of the Republicans and their manipulations and would risk it all by making the ultimate sacrifices to save this democracy?? As opposed to the idiots out there who through ignorance and fake news are trying to destroy it possibly not understanding what they’re doing. Ergo civil war?
Nope, I’m suggesting nothing about patriots or idiots. I’m simply observing that the paupers with pitchforks also have pipe bombs and they are now openly talking about a civil war that could destroy our fragile infrastructure. In which case; yours, mine and Warren Buffet’s US stocks and bonds could be worthless.
One difference between now and the 70’s is the politics. Back then Parties had differing views about issues. Both republicans and democrats had loved ones dying in Vietnam, loved ones who were drafted. The filibuster hadn’t gone nuclear. Legislation could be passed with votes from both parties. I guess this is a long winded way of saying government today no longer works and a significant number (maybe 30+%) of citizens are heavily armed and have no relationship with facts or the truth. Add that to economic analysis and a Goldman forecast might be the least of our worries in 2024.