One of the prominent themes of our newsletters this year has been inflation. Inflation rates for countries globally have hit decade, and in some cases, multi-decade highs. Even the Federal Reserve, long champion of the “inflation is transitory” argument, has shifted its outlook and become more concerned. As economic growth has recently slowed, many pundits are making comparisons to the 1970s, a period characterized by double-digit inflation rates and rising unemployment. The suggestion of a parallel between the ‘70s and now is incorrect.
The Uniqueness of the 1970s
Understanding the ‘70s requires understanding the ‘60s. The 1960s were, in many respects, the last hurrah of a growing and prosperous middle class in America, a time when incomes were relatively equivalent and economic class distinctions were far less severe. Wages outpaced inflation for all workers in the 1960s, something that has not happened since. Johnson’s Great Society government programs began in this decade. American households entered the ‘70s financially secure. The baby-boomer generation came into their peak household formation level and prime consumption years in that decade. The 1970s started, in other words, primed for inflation due to demographics and growing consumer demand.
If the 1970s began primed for inflation, the events of the decade served to compound the problem. Nixon took the US off the gold standard in 1971, which lowered the value of the US dollar and increased the cost of imports. When the oil embargo started in 1973, a cheap dollar added insult to injury. Between ’73-74, a time when crude oil was twice as important to the economy as it is today, the price of oil jumped 400%. By the middle of the decade inflation peaked at 12%, and unemployment was at 9%. The 1970s experienced three recessions in what was termed stagflation, a contracting economy with increasing prices.
When reviewing the experience of the 1970s it is important to realize how unique the period really was. There was a confluence of events and an economic structure that is simply not present today. Thirty percent of workers had cost of living adjustments through their union contracts. This forced employers to increase wages every 18 months regardless of the condition of their businesses. Eventually this connection increased unemployment as firms were simply unable to meet labor’s contractual wage demands. Fewer businesses providing goods and services increased supply shortages, again pushing up inflation. This negative feedback loop of wages and prices went on until Fed Chairman Paul Volcker dramatically increased interest rates to push the economy into a fairly painful recession at the end of the decade.
The demographics of the era were a huge contributor to inflation. Baby boomers needed homes and consumer goods for their growing families and had 20% of US household wealth to pay the bill. This type of demographic surge would be a strong enough effect to create supply shortages and higher rates of inflation by itself, without the impact of a weak dollar and oil embargo. Simply put, the 1970s were a perfect storm of inflationary factors.
The Economy Today
Comparisons between today and the 1970’s are unfounded, but we can see the allure. Here are the similarities:
- Similar to the 1960s, Americans are wealthy. US household wealth has grown by $16 trillion since 2019, an unprecedented rate.
- Oil prices have increased from zero to $80 a barrel in a year and a half.
- Wage growth is above the current rate of inflation for some workers
- Job switchers, the modern equivalent of union COLA contracts, are enjoying wage growth above the rate of inflation. The number of workers switching jobs is at a 25-year high.
- The US government is currently debating the merits of the largest increase in social spending since the 1960s.
- Millennials are in their prime household formation years and Gen X is in their prime spending years.
That’s a mirror image of the conditions that contributed to the inflation problem of the 1970s, without Nixon taking the US dollar off the gold standard. The comparisons are easy to make, but they are based on sloppy logic.
From a wealth perspective, there are trillions of dollars on the sidelines available to fuel demand and increase prices. The catch is that 53% of this figure is in the hands of baby boomers, who aren’t in any hurry to spend. Gen X accounts for 8% of household wealth today and millennials 4%. The generations most willing to spend wealth to fuel the demand needed to create inflation do not have the assets to do so. Baby boomers have the assets but are more inclined to maintain high savings and investing rates. This is great for asset prices and has promoted record levels of new money moving into the stock market, but this fact is terrible for the inflation argument.
Wage growth is the greatest contributing factor to inflation. Low-income workers saw their real wage (adjusted for inflation) decline in the previous decade. This was the first time that has happened to any group in the history of the US, with data going back to the Civil War. This same group, the bottom 25% of wage earners, is the only group currently experiencing wage increases at a rate greater than inflation. The top 75% of workers have seen real wages decrease this year. The wage-price spiral that characterized the 70’s simply is not present for 75% of workers, even after accounting for the number of job switchers.
Energy prices are certainly higher, on a percentage basis, over the past year as OPEC has limited supply and domestic producers are still reluctant to increase production. However, the US economy is much less energy intensive today than 50 years ago. For oil to have the same economic and inflationary impact that it had during the oil embargo, it would need to move towards $400 a barrel. Today a barrel of Brent Crude is trading for $82. The most bullish analysts are calling for $120 in 2022.
Government spending on social programs does not create inflation. The argument that it does is based upon economic theory so discredited that even the originator of the theory (Milton Friedman) changed his mind by the end of his career. The argument that the US is heading towards 70’s style stagflation is simply unfounded. It’s an argument made for political, not economic, reasons.
Why is Inflation Still So High?
COVID is the simple answer. The two ways this is most clearly expressed are through the labor market and supply chain bottlenecks. Roughly two million prime working age people left the workforce over the past year and a half due to childcare and health concerns, according to survey data. When these people feel comfortable enough to return to work, the labor shortage will be over and wage growth for low-skill jobs should normalize. The obvious problem is that no one knows when these two million people will feel comfortable returning to work. The likely answer is at some point in 2022, especially now that vaccines are available to children between the ages of 5–11. It is also past time for low-skill workers to see wage gains. This group has been falling behind for a decade, so it is easy to understand why they’re holding out for higher wages and better working conditions.
The significance of bottlenecks affecting global supply chains is hard to overstate. Excluding food and energy, 45% of consumer goods are imported to the US from overseas. Frankly, its amazing shortages haven’t been worse given the 20% increase in demand for consumer goods relative to 2019. Global supply chains are long and complex and were stretched even before the pandemic. For example, the production of a typical computer chip, the oil of the modern economy, involves raw materials from, and assembly performed, in 32 different countries. Thirty-two countries all with different COVID restrictions, lockdowns, worker shortages and logistical issues. China, with a zero-tolerance COVID policy, currently has 11 of 23 provinces under COVID mobility restrictions.
There are tentative signs that logistical bottlenecks are easing. September and October are the busiest months for the import of goods for the holiday season. Shipping costs are now declining, although they remain elevated. Recent research has suggested that due to shipping costs and a weaker US dollar, prices of imported goods should be 8-10% higher than they are today. This means that foreign suppliers increased the production of goods over the past year, keeping prices down, relatively speaking. Without a limit in supply relative to demand, the economy cannot have sustained inflation.
The Current State of Affairs
Given the vaccination trajectory in Asian countries and planned distribution of vaccines to US kids (a piece of the labor puzzle), inflationary pressure may persist for another 9-12 months, with a big margin of error to that estimate. The Fed isn’t willing to wait that long and intends to take steps to cool the economy. The “tapering” (slowing) of the Fed’s asset purchases should begin soon. The interest rate market thinks that the first interest rate hike will happen in the fourth quarter of 2022, if not sooner.
Inflation has been a positive for domestic equities throughout 2021. This suggests that investors, up to now, have viewed inflation as a proxy for increased economic growth and strong corporate earnings. Our internal models show that this correlation has flipped to negative over the past week, meaning the market now views any inflation readings above expectations as negative for US stocks.
Our portfolios have been designed to hedge inflationary risks through exposure to real assets (TIAA Real Estate is up 13% YTD) and inflation sensitive equities. Although we do not believe inflation will be a pressing issue in 18 months, these types of investments still appear more attractive than the “Covid winners” that excelled in 2020.