Historical comparisons are vital for any serious investor. Not because the past always repeats itself, but because it gives you a sense of what forces are at work and how they are likely to shape events. The tricky bit, however, is deciding which historical parallel is the right one.
In the debate between whether we are looking at a decade of deflation or inflation, for example, too much attention is paid to where we are right now. At the start of the 1970s, there was little to suggest that rising prices were going to be a problem any time soon. Nor was there much sign that mass unemployment lay ahead. But, as a fascinating recent analysis by Morgan Stanley made clear, there were four forces at work in the late 1960s and 1970s that were to pave the way for stagflation – rapid inflation combined with zero or minimal growth. All have very clear parallels today.
Back then there was an international monetary system, which meant that the expansionary policies of the Federal Reserve were exported around the world. In 1970, it was the Bretton Woods system that had been set up after World War II. Today, it is quantitative easing. But the net result is much the same. The Fed is trying to inflate its own economy, for its own reasons, but much of the expansion of the monetary system ends up elsewhere.
There was also a glut of dollars flooding onto the global economy. In the early 1970s, America was printing money to finance the Vietnam War. Now it is doing so to keep its banking system afloat, but again the net impact is very similar.
There was also a twin-track global economy. In the early 1970s, the peripheral economies – in those days mainly Japan, and the emerging Asian economies such as Hong Kong, Taiwan and Korea – were growing very fast. Meanwhile, the main traditional economies were starting to stagnate.
The same is true today, with the emerging markets racing ahead while the established giants of the global economy have all slowed down sharply.
Then there were structural challenges to the old heavy-weight economies. These meant they found it very hard to grow. In the early 1970s, they were faced with the loss of old, basic manufacturing industries and the creation of new service-based economies. In 1970, for example, 35% of British jobs were still in manufacturing, compared with only 13% now. It was impossible to grow very fast back then until that transition was complete. Now, of course, it is debt de-leveraging: gradually restoring both personal and government balance sheets after the crazy borrowing spree of the last decade. That also means that growth is likely to be very subdued for a long time to come.
Of course, there are differences as well. No historical comparison is ever perfect. For starters, there is none of the wage indexing now that was common in the 1970s. When wages went up with inflation automatically, that ratcheted prices upwards endlessly. Today, wages are falling in the UK in real terms – they are rising at about 1% less than inflation – and in most of the developed world as well.
Meanwhile, the Opec oil cartel is nothing like the force it was 40 years ago – it isn’t going to be able to force up the oil price in the way it did in the 1970s. Still, the parallels are clear enough.
On balance, several years of stagflation looks the most likely outcome. How should investors respond?
First, don’t worry about inflation just yet. Although the main ingredients of stagflation were all in place by the beginning of 1970, inflation didn’t take off right away. It wasn’t until the oil crisis of 1973 that prices really started to run riot. And it was the second half of the decade that saw rampant inflation across much of the developed world. You need to reckon on the big upturn in prices around 2013 or 2014 – not this year or next. So, for the time being, you are fine remaining invested in assets such as bonds that don’t protect you from rising prices. They will carry on doing well for at least another two years.
Next, switch into real assets. With zero growth and rapidly rising prices, you need to be out of cash. The outlook for property prices might seem bleak on the surface, with squeezed incomes and little growth in lending, but for British investors there have been few better long-term hedges against inflation than houses and land. Gold will do well. So will commodity prices. Even better, try and spot the next Opec-style cartel that can take advantage of loose monetary policy to squeeze up prices – iron ore would be one possibility.
Finally, get ready for the clampdown. Central banks remain remarkably relaxed about inflation. They may have decided that with so much debt on personal and national balance sheets, modest inflation is the best way of getting the economy back into shape. But eventually, inflation will have to be squeezed out of the system. That will create a lot of losers.
Sure, at the end of the cycle we should be back in the early 1980s – ready for another big bull market in equities. But that part of the story is still a long way off.