An energy shock and high inflation: are the 1970s reborn?

Those of us who remember the 1970s, even as children, are getting nervous. No decade is all bad. But very few of us would like a repeat of the inflation, the endless financial stress, the poverty — and in the case of many families (mine included) the migration in search of work.

Unfortunately, so far the 2020s are feeling rather too much like the 1970s for comfort. Dario Perkins of research group TS Lombard lists the ways. The 1960s saw one of the longest expansions on record. It also saw a flattening of the Phillips curve — that is, falling unemployment was not correlating with rising inflation in the way one might expect.

That emboldened policymakers to both prioritise full employment over low inflation (inflation did not appear to be the relevant risk) and to develop more activist fiscal policy.

This was the backdrop to a fabulous bull market. The FTSE All-Share index doubled in the two years to January 1969, when it peaked on a record price/earnings ratio of 23 times.

Then came a huge energy shock which built on previous inflationary rumblings. The Phillips curve normalised, wages started rising and the money supply surged. Policymakers blamed temporary factors — and stripped them out of the inflation numbers they used as their reference point. It was “transitory”, you see.

It sounds horribly familiar, doesn’t it? Particularly now that, notwithstanding Thursday’s sharp fall in the oil price, the energy price shock of the past few weeks is of 1970s-style magnitude.

Perkins is not convinced that we need to get as tense as I am beginning to feel. There is, he says, a huge and crucial difference between now and then, in the UK at least. Then, labour had power. Now it does not. Our population is not so young and “militant”, our trade unions are weak, our markets are much more open (companies can’t get away with price rises in the same way) and pretty much no one — pensioners and MPs aside — has their income in any way indexed to inflation. All that means that a wage price spiral can’t get going in quite the same way.

He might be right. I’d argue that workers will rebuild their bargaining power pretty quickly in the face of CPI inflation hitting 10 per cent. It is worth remembering that in the 1960s pay lagged behind inflation for some time before pressures appeared. There were murmurs in 1966 from the railways and the coal mines and things then took a turn for the seriously worse in late 1969 when Ford Motor workers went out on strike.

Still, whichever of us is more right — forecasters are rarely completely right — one thing is for sure. We won’t be going back to the 2010s. 

The deflation machine that has been the driving force of the past few decades is properly broken, something that is fast turning out to be a terrible shock to fund managers who have only ever worked inside said machine, and so have hard-wired into their behaviour an assumption that moderate inflation and low interest rates would last for ever.

With globalisation reversing, labour costs at best no longer falling and the structural supply problem with materials and energy increasingly obvious, prices of pretty much everything must now rise. A reminder for those who think there is an easy way out: you need fossil fuels to make wind turbine blades and solar panels and you need a lot of nickel — up 90 per cent in two weeks — to make electric car batteries.

The question is just how much prices must rise, how fast and with how much volatility. That we can’t know. The war in Ukraine gives us some unpleasant clues about the short term (up a lot, very fast and with a lot of volatility) but the overlay of uncertainty means we can’t guess much more than that. Who knows, for example, what might result from attempts by money-printing governments to protect households from the sharply rising food prices caused by the horrors in one of the world’s most reliable producers of grain?

It would be nice to think some markets are nearly there, particularly the US, which is at less risk of war-related recession than Europe. They aren’t

So where are the financial safe havens? You might think that as long as inflation stays in the 1 to 4 per cent region (Perkins’ guess) you’ll be safe in equities. That’s what we are often told. But it isn’t always so.

UK inflation only tipped over 5 per cent in 1969 but investors still lost out hugely in the 1960s: the market went up 20 per cent and prices went up 43 per cent. Extend it into the stagflationary 1970s and things look pretty bad too. From October 1964 to May 1979, a period which encompasses two Labour governments and one Conservative, UK stock market investors lost 31.7 per cent of their money in inflation-adjusted terms.

So much for the idea that an equity index can protect you from inflation, stagflation — or indeed anything else. The good news is that the one way an equity market can protect you is if you buy it at the bottom — the best long-term returns come from buying cheap markets.

It would be nice to think some markets are nearly there, particularly the US, which is at less risk of war-related recession than Europe. They aren’t. For that, we would need to be sure there was another wave of central bank money on the way, to know that energy prices are on the way down and to be sure that valuations are compelling. None of these things are true, or anywhere near to being true. For example, the Shiller price/earnings ratio for the US is still over 30 times against a long-term average of more like 16 times.

Waiting for them to be true is a slow process. Russell Napier, a market historian, likes to point out that the four great bear markets in the US lasted on average nine years each. In the intervening period, you should get some protection from commodities and from gold — you did in the 1970s.

But you would also be wise to look at multi-asset funds run by managers who have long known that the deflationary machine would break and who are invested accordingly. Look at Ruffer Investment Company, which is up a little in the year to date, Personal Assets Trust and Capital Gearing Trust. They are more ready than most.

Merryn Somerset Webb is editor-in-chief of MoneyWeek. The views expressed are personal; merryn@ft.com; Twitter: @MerrynSW. She has holdings in Ruffer Investment Company, Personal Assets Trust, Capital Gearing Trust, gold and commodities