There is clearly a difference of view about the 1970s. It was the decade of surging oil prices and power cuts, trade union militancy, complacent companies, funny clothes, and stagflation – that intriguing mixture of low growth and high inflation.
But equally, it wasn’t all bad. 1976 is a reminder that hot summers are not just a current phenomenon; there was a freedom of thought that seems to have eroded now; and there was resilience, reflecting the trauma of war and rationing that was within living memory of most of the adult population.
A question I get asked is whether we are returning to the 1970s: stagflation and energy crises coupled with strategic drift and diminished world status. As someone educated through the British university system of 40 years ago, I can argue either way.
Let’s look at the case for stagflation: the inflation element reflects the pressures in the energy market (especially gas) and the supply disruptions brought about by Covid and Brexit. The Bank of England sees Consumer Price Index (CPI) inflation above 4% in coming months while the market is pricing implied Retail Price Index (RPI) inflation at nearer 6%. High levels of vacancies indicate that wage growth may continue to accelerate and if confidence wanes in the UK economy we could see imported inflation through a weaker pound. Add in the possibility of higher mortgage rates as market interest rates firm and the inflation outlook looks challenging. The stagflation story needs growth to be subdued and a case can be made: higher taxes on companies and employees, withdrawal of the Universal Credit uplift, pressure on disposable income through energy and mortgage costs – all suggest a squeeze on businesses and consumers.
Against this, I think there are at least three scenarios that can be undermine the stagflation argument – but the outcomes are radically different. In the first, inflation proves to be transitory. Supply disruptions are addressed, Russia produces more gas, and inflation falls back to towards the Bank of England’s 2% CPI target. This outcome is benign for markets: rates go up a bit but we remain in a low inflation world.
The second outcome is that growth surprises on the upside. The proposition is that the wall of global savings accumulated by the private sector will be unleashed on services and consumer durables, propelling global growth. I don’t buy into that but have been repeatedly surprised by the ebullience of US consumers over the years.
The third scenario is the most problematic for risk assets: we are heading for a global recession and that it is not inflation we should be wary of – but the opposite. This seems unlikely but is coming onto my radar screen. China is a worry: its real estate market is rapidly deflating, businesses are facing higher costs and we just don’t know how consumers will react in a Covid ‘light’ world.
So – is that much help? I have put forward both sides of the stagflation argument. My view is that stagflation, as we knew it in the 1970s, is very unlikely. Global economies, goods and financial markets are highly integrated. This means adjustments tend to be more brutal and quicker – if required. We have run short duration positions in government bonds (asset allocation and duration) for some time. Despite the headlines I am wondering whether it is time to temper that view. I will keep you updated.
Cash and government bonds
Will the US default on its debts? No chance – let the media have their way and build up the story – but in my view it’s not going to happen.
US data was mixed. Non-farm payrolls were weaker than expected at 194K, below consensus of 500K. However, there were sizeable upward revisions to the previous month’s figures, the downside surprise in private payrolls was smaller than in the headline figure and the unemployment rate fell more than expected to 4.8% from 5.2%. Average hourly earnings growth was in line with expectations at 4.6%Y. Will this lead to the US Federal Reserve starting tampering in November? I think so.
The yield on 10-year UK government bonds rose materially in the week, taking yields towards 1.2% and in the US rates went above 1.6%. Euro area yields were less impacted but reflected the move higher. Implied inflation continued to strengthen – not surprising given the move up in energy prices. Despite the negativity about the UK, sterling strengthened on the week.
For the first time in a while sterling investment grade credit spreads came under pressure. New issues did not see the usual ‘book-building’ tango – an initial enticing spread is eventually whittled away. Inventory of sterling credit is probably a bit higher than desired as a result. Looking at indices, sterling spreads widened 2-3 bps, taking overall yields back above 2% for the first time this year.
High yield markets were more impacted by market volatility, with spreads widening another 10-15 bps. Emerging market credit remains a problem area – with sentiment dragged down by the problems of the Chinese real estate sector.
Returning to my theme: despite the re-activation of ABBA I don’t think this heralds a return to 1970s economics – the world has moved on. But also, let’s keep things in perspective. Surveys consistently show that people were happy in the 1970s with 1976 often considered the year when the UK, as a whole, was happiest. Actually, from the perspective of a 14-year-old, it was a great year.
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