Are we going back to the 70’s? Parallels between then and now.

Cast your mind back to the 1970’s. Long-hair, moustache’s, bright colours, leisure suits and disco.

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In the words of Novelist Tom Wolfe, this would become the “me decade” – a new attitude of individualism.  Instead of global conflict and social justice of the 40, s, 50’s, 60’s, the ‘me decade’ had become obsessed with inflation, unemployment, and other measures of economic malaise.

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There are numerous parallels that could be drawn between the 70’s and now. We are witnessing an energy crisis in Europe. Like the oil shock in the 70’s. We are coming out of our own ‘post-war’ period against Covid, with huge amounts of government spending lifting the wealth, or savings of households. Equally, we have significant government deficits from such spending – without commensurate taxes. We have seen a surprise attack of Ukraine, just as Arab states had against Israel on Yom Kippur. Both resulted in sanctions and had ties to Russia and the West.

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Blockchain and cryptocurrency could be our modern equivalent of ending the ‘Bretton-Woods’ era. Concerns about inflation, recession, or what ‘stagnation’ means also hold today as they did then.

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I started writing this note, first as a history lesson for myself, looking for parallels between then and now before realising, further to Craigs last note, there are important differences to make today; compared to the 1960’s, 70’s and 80’s that will result in very different outcomes for investment markets. As Craig relayed in his previous note, “history doesn’t repeat itself, but it does rhyme.” There are lessons that can be drawn from that past, but it would be wise to do so with a grain of salt.

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Inflation is structurally lower

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At its simplest, the long-run drivers of growth for an economy are primarily a factor of two things: 1. Population growth; and 2. productivity of that population. As the population increases, so too does the amount of goods and services produced; and equally the amount consumed. If we lived in an economy that only produced bread – a larger population would need to produce and consume more loaves of bread. The second determinant is productivity, or innovation. As a population innovates, it becomes more efficient with resources and can produce goods or services more easily. It can automate certain tasks and each worker, in conjunction with technology, can produce more things.

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If we are comparing the 70’s and today; two key differences are in population growth rates; and technology. In the 1970’s population growth was averaging ~2% per annum. In the last decade (2011-2021) it averaged 1.20% and today, it is averaging 0.90% per annum.  Population growth rates have been on steady decline since the 60’s and is expected to continue trending lower for the decades to become – meaning the level of production required to provide for this population will not need to continue at the same rate. In other words, demand is structurally lower. Productivity today is also leaps and bounds above the 1970’s. Digital technologies such as personal computers, smartphones, wireless internet, cloud computing, machine learning, robotics, DNA sequencing, targeted advertising and e-commerce are some examples of the many tools people and businesses are using to improve efficiency and productivity today, which didn’t exist in the 70’s.  

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Following World War II, technologies from the second industrial revolution like the car and plane, global trade accelerated. Institutions like the European Union and other free trade vehicles championed by the US, were responsible for much of the increase in global trade. When the wall dividing East and West fell in Germany, the Soviet Union collapsed. Globalisation became an all-conquering force. The World Trade Organisation encouraged nations all over the world to enter into free-trade agreements, and many did. In 2001, even China which had been largely secluded, became a member of the WTO, and started to manufacture for the world. A new technology from the Third Industrial Revolution, the internet, connected people around the world in a new way. This allowed for further integration of global value chains – R&D, sourcing, production, and distribution could diversify and occur globally, capturing new efficiencies – skilled labour, savings, or both. Global trade as a share of Global GDP moved from 25.00% in the 70’s to approximately 60.00% today.

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Consequently, inflation is structurally lower today than in the 1970’s. Innovation allows businesses to produce goods and provide services much more efficiently today. Global trade is significantly higher, driven by efficiencies that can be captured by diversifying global supply-chains. We can produce goods and provide services with less people, reducing labour demand. Jobs can be outsourced offshore for cost or productivity efficiencies. Growth in consumption will slow as population growth does.

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The weaponization of trade and energy

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Despite structurally lower inflation, short-term supply issues can have a much greater impact on near-term inflation numbers today. Given global trade is responsible for so much economic output, and because supply-chains have become increasingly integrated – a disruption in one country can more quickly snowball into others. Globalisation in the last 40-years has seen significant outsourcing of manufacturing to lower-cost countries like China, creating industrial base vulnerability.  Similarly, countries that haven’t sufficiently diversified commodity supplies, have become increasingly vulnerable – just as we are seeing between Russia, Europe and potentially Japan given its dependence on Russian energy. It is not a new phenomenon for countries to weaponize trade-relationships, sanctions, or commodities as a tool for persuasion in geopolitical conflict. In fact, the emerging energy crisis between Russia and Europe is something that President Biden, Trump, Obama warned about, as did Regan and Nixon over 40-years ago.

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To quote Biden in 2016:

“Europe needs diverse sources of natural gas, not, in our view, a Nord Stream 2 pipeline.” He went further to say, “to lock in great reliance on Russia will fundamentally destabilize Ukraine.”

Earlier warnings occurred four-decades ago, with a C.I.A memo stating unequivocally that:

‘The 3,500-mile gas pipeline from Siberia to Germany is a direct threat to the future of Western Europe’, creating “serious repercussions” from a dangerous reliance on Russian fuel.

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Moscow, on several occasions, has cut off gas supplies to Ukraine, during various territorial disputes. Back in the 1970’s, when Germany expressed an intention to sign a gas agreement with Russia as a peacetime opening to a former foe, it assured NATO that Germany would never rely on Russia for even 10% of its gas supplies. Today, it supplies over half of its gas and about a third of all oil. In the first two-months after the start of Russia’s assault on Ukraine, Germany is estimated to have paid E8.2bn for Russian energy. EU countries are estimated to have paid a total of E39bn – more than double the sum given to help Ukraine defend itself. The irony is painful. As historian Timothy Snider wrote “for thirty-years, Germans lectured Ukrainians about fascism. When fascism arrived, Germans funded it, and Ukrainians died fighting for it.” The former Soviet and Russia have strategically focused on encouraging energy dependency to harbour it as a weapon – for decades.

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Reorganising global supply is a strategic priority

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As I touched on in my last two notes, here, and here, companies began revisiting global-supply chains after the onset of the pandemic; and countries were forced to do the same. Priority has moved from a focus on efficiency, through Just-in-time supply models, to one of resilience. How do we best ensure security of strategically important goods or services [for the business or country]? The energy crisis in Europe is highlighting the risks of relying on an ‘enemy state’ for strategically important goods or services; and this is occurring in the backdrop of an increasingly divergent East and West that have different values. I had emphasised in earlier notes, that it is a strategic priority for governments to rebuild their industrial base, onshore or ‘friend-shore’ production, which require significant investment by corporates and governments. Higher interest rates, while deterring entrenched inflation of the 70’s, would be a policy mistake because it would discourage investment in supply-chain resilience. In my opinion, this is a greater policy issue than above-trend inflation.

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There are many issues that will need to be addressed post this period, enabling new opportunities.

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• How will Europe (and Japan) diversify their energy needs away from Russia?
• How will the world address future health challenges such as emerging pandemics?
• How will corporates diversify away from dependency on Chinese manufacturing?
• What would happen to Chinese manufacturing if it invaded Taiwan (look at Russia)?
• If jobs return to the West, will executives choose labour, or replace them with technology?

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I don’t have the answers to these questions. However, the solution will require new investment to diversify production and supply. Significant spending will be required to execute on this, creating new investment opportunities with friendly nations, and high inflation – and rates, are likely to be secondary to this spending. Energy security, health, strategic production can be life or death.

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While inflation remains structurally lower, there are two dislocations from changes global supply-chains. First, onshoring or friend-shoring may be viewed as a form of deglobalisation. This will be inflationary, driving up the short-medium term costs of production. The second is regarding productivity. If production is brought back to the West, businesses are unlikely to replace low-cost Chinese or emerging market labour. Instead, they would likely invest in more efficient technologies, robotics or automation that eventually boost productivity. Ultimately, this will be deflationary. To summarise – inflation remains structurally lower but will be elevated whilst supply-chains diversify.

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Markets, valuations, outlook

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The main driver of year-to-date returns have been a shift in central bank policy, aggressively hiking interest rates. These measures were taken by Central Banks to avoid a 1970’s style entrenchment of inflation, but in my opinion, there are big differences between Central banks today and then.  

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In the 1970’s there was:

1. A lack of understanding that inflation could rise, while economic growth slowed (stagflation);
2. no formal inflation target for central banks, and therefore a slow response to addressing it.
3. a lack of communication on inflation risks, which led people to assume that little would or could be done about rising prices. People expected increases to continue (so they did).

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That can be contrasted with actions in the last 9-months. Central banks shifted their policy stance very quickly, which surprised markets in November. This aggressiveness highlighted a difference in policy today vs. 1970. It didn’t take a decade to shift policy, it took a matter of months. When commentators say we are going back to 1970’s inflation, they are wrong. Central banks are a totally different beast today. Another core mandate today is financial stability. For countries like Australia, our sensitivity to the housing market is paramount to policy. Raising rates in line with market expectations, at least how they are currently priced, would result in a catastrophic outcome for our property market. Because of this, we believe central banks have a ceiling, limiting the cash rate to approximately 2.50%. Not 3.00% to 4.00% as the market currently has priced. Even with a modest 2.00 – 2.50% cash rate, property values could decline by 20-30%, reversing price gains made because of the pandemic stimulus. Cutting rates led to these price rises, so increasing them can reverse it.

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Unlike the 1970’s, banking and consumer lending has also become much more mainstream. It’s not only those with the highest creditworthiness that get to borrow today. There are now many different products and providers of credit, readily available. Household debt to income levels today, are upwards of 2-3 times disposable income; compared to less than 0.4 times in the 70’s. In other words, we are 5 to 7.5 times more sensitive to interest rate rises today. In context, a 2% rise in interest rates, could feel like a 10 -15% rate rise in the 70’s due to the relative increase in debt to disposable income levels today versus then. This isn’t precise, but hopefully illustrates my point.

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I believe that the point of the RBA, and other central banks ‘shock and awe’ approach, it to set cautious expectations for households and businesses. By communicating a willingness and intention to raise rates aggressively in the future, it can become a self-fulfilling effect. Households will cool spending and save money in anticipation of that occurring, which better insulates them. Unlike during the 70’s people will reconsider borrowing costs; will look to de-lever; cut costs and increase savings earlier than they had planned. Once expectations are lower, inflation will also be lower.

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What if Central banks disregard this and raise rates more aggressively?

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If Central banks raise rates as aggressively as currently priced, despite rising costs in consumer staples like food and energy; and businesses absorb higher input costs (labour, materials), negatively impacting corporate earnings– the economy will enter a recession. Central banks using the only lever they have, could push the economy into a period of 70’s style stagflation – high inflation, low or negative growth and relatively high unemployment. This scenario would be negative for markets and a policy mistake. A severe shock could be felt across direct Australian and global property assets.

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This carries two scenarios. The first is a recession, which arguably some countries are already in. Normally in a recession, Central Banks would ease monetary policy by freezing, or reversing rate increases. A positive for markets.  The second scenario is a recession with stagflation, where central banks continue raising rates despite negative economic growth. This would be negative for markets – particularly for property or leveraged assets, with further declines.

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In our view, we do not see a scenario of recession and stagnation playing out. If we do, however, print a recession (not stagflation), the average decline in this environment is 35-percent. So provided year to date declines, a recession has already been 70-90% priced into markets. Earnings results in Australia and globally have remained resilient thus far. In aggregate, earnings have grown by 9.2-percent (or more) year-on-year and while we expect this to slow, it should remain steady through 2022. Corporate balance sheets are healthy. We see the most likely scenario as central banks pausing rate rises near the end of this year, with the cash rate sitting at c. 2.00%. This would be a 1-2% lower cash rate then the market implies – leading to a positive rally in risk assets.

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In the near-term, corporate earnings are likely to decline as supply-constraints and disruptions increase costs and reduce profit margins, however, for real estate, information technology, energy and materials, profit margins remain above their 5-year average. It is not the time to be passive in markets. There are attractive companies trading at a significant discount to fair value.   Many companies will continue to grow in an inflationary environment, a recessionary environment, or almost any other – but their success is reflected in operating metrics, not pricing.

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Like Tom Wolfe ascribed to the 70’s, the 2020’s could become a new ‘me decade.’ Albeit with important differences. Instead of being focused on a period of higher inflation, lower growth, or economic welfare – it will also consider the vulnerabilities created by dependence on foreign adversaries for strategically important goods or services.

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Instead of the ‘me decade’, this could very well become the ‘our decade.’ A period of new, strengthened Western Alliances; where local investment, onshoring, friendshoring, and significant infrastructure spending revitalise our industrial base. Driving a new productivity boom, which creates enormous opportunities for people and businesses that plan for and capitalise on a new post-pandemic World…

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Until next time,

Ryan.  

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*Annual Population Growth data, The World Bank, accessed July 2022.

*International Monetary Fund (IMF, 2022).

*Global trade as a % of GDP data, The World Bank, accessed July 2022.

*Abnett, K, EU Says Halt to Nordstream 2 would not affect bloc’s energy supply’, Reuters, February 2022.

*Tabuchi, H, ‘How Europe Got Hooked On Russian Gas Despite Reagan’s Warnings’, NY Times, March 2022.

*Wintour, P, ‘We were all wrong: how Germany got hooked on Russian Energy’, The Guardian, June 2022.

*RBA Chart Pack, July 6 2022 < https://www.rba.gov.au/chart-pack/household-sector.html>

*La Cava G and Simon J, A Tale of Two Surveys: Household Debt and Financial Constraints in Australia (2020)

*Ned Davis Research, as of 15/12/2021

*Based on peak YTD S&P500 price, to low, representing a 25% decline; and Nasdaq, a 33% decline.

*Buttlers, J, Factset, earnings insight, June 2022.

*Buttlers, J, Factset, earnings insight, July 2022.

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