Today we will dedicate our “Data” section to stagflation, with 3 points on the history of the phenomenon and how US stocks and real estate have done when it occurs:
#1: Definition and historical analysis. Stagflation is a portmanteau word, combining “stagnation” and “inflation”. It signifies the unusual combination of fast-rising prices and either slowly growing or declining economic output.
The chart below shows annualized real US GDP growth (black line) and Consumer Price Index inflation (red line) back to 1960, and it neatly tells the story of why stagflation is such a hot topic just now:
- In the 1960s, US inflation rose through the decade from 1 percent to 5 percent due to a strong domestic economy as well as spending on the Vietnam War and new social programs.
- Starting with a recession in late 1969 and ending with another one in 1982, the US economy went through a long period of stagflation. Inflation rose through the decade and was always higher than GDP growth.
- Fed Chair Paul Volcker famously brought the stagflation era to a close by raising interest rates enough to cause a sharp recession. This finally broke the economy’s inflationary impulse after over a decade of +5 percent annual CPI increases.
- From 1983 – 2020, inflation was largely below 5 percent, real GDP growth generally matched inflation, and inflation dropped during recessions (as it should).
- With a hot US economy and supply chain disruptions/inventory shortages, some investors worry that we are setting up for a period of 1970s-style stagflation. The economy is capacity constrained (keeping growth low) and both producers and workers have pricing power (keeping inflation high).
#2: US stock price performance and corporate earnings during 1970s/early 1980s stagflation.
First, here is the part you likely know: S&P 500 total returns during this period were volatile, and not just because of stagflation (note 1973 – 1974 oil shock returns):
- 1970: +3.6 percent
- 1971: +14.2 pct
- 1972: +18.8 pct
- 1973: -14.3 pct
- 1974: -25.9 pct (note: 2-year drawdown of 37 pct, as bad as 2008)
- 1975: +37.0 pct
- 1976: +23.8 pct
- 1977: -7.0 pct
- 1978: +6.5 pct
- 1979: +18.5 pct
- 1980: +31.7 pct
- 1981: -4.7 pct
- 1982: +20.4 pct
Now, here is the part you may not realize: even with all that volatility, the S&P 500 kept pace with CPI inflation during the stagflation of the 1970s – early 1980s. It did not beat the Consumer Price Index by much, but it did hold its value:
- CPI Inflation, 1970 – 1982: +159 percent
- S&P 500 total return, 1970 – 1982: +169 percent
The reason US stocks kept pace with inflation during this period comes down to two words: corporate earnings. As the chart below shows, US corporate pretax earnings (blue line, indexed to 100 in 1970) tracked dollar for dollar with CPI inflation (red line, same index) from 1970 to 1982. They were even nicely ahead of inflation until the 1980 – 1982 recessions reduced corporate profitability.
#3: There is a popular belief that US residential real estate did exceptionally well during the 1970s – early 1980s period of stagflation, but Robert Shiller’s historical home price dataset (link below) says otherwise:
- From 1970 to 1982, the median American house appreciated by 159 percent, exactly the same as CPI inflation (see above).
- Home price appreciation never went negative during this period, but it was below 1 percent annually during the 1973 and 1982 recessions.
- Throw in the financial leverage from a mortgage, and owners of US residential real estate certainly did beat inflation, and with much less volatility than stocks. This feature, not actual asset price returns, is likely why many people believe housing is an inflation/stagflation hedge.
Takeaway (1): When considering stagflation as a threat to equity prices today, it is important to separate the effect of the 1973 – 1974 oil shock recession from the rest of the historical record for the 1970 – 1982 period. The 73-74 recession had a devasting effect on stock prices. Conversely, persistent inflation thereafter helped corporate earnings tremendously and had a beneficial effect on equities. Put another way, if a savvy investor had been out of equities in 1973 – 1974 but otherwise fully invested from 1970 – 1982 they would have very handily beaten inflation during an otherwise stagflationary period of US economic history.
Takeaway (2): Recession – not stagflation – is, therefore, the real risk to US stocks right here. Three thoughts on that:
- At one level, that is reassuring. The American economy is still strong, job openings remain well above the number of unemployed workers, and supply chain constraints should start to ease later this year.
- At another level, we have high oil prices due to a geopolitical shock (reminiscent of 1973 and 1979) and a Federal Reserve set on raising rates to reduce inflationary pressures. Has inflation ever come down meaningfully without a recession once it breaches 5 percent? No, it has not (check the chart above…)
The tension between these 2 points will not be resolved soon, which is why we expect equity market volatility to continue.
S&P Annual returns: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
Shiller Home Price Index: http://www.econ.yale.edu/~shiller/data.htm