– too much inflation, too little growth – could become a damaging mixture
 

“I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year”

The Merchant of Venice

Here comes stagflation – a nasty word for a nasty condition.  Today’s financial headlines refer to little else.  Generally couched in desiccated economic jargon, the implications may not be clear to all readers.  Some may well conclude that the economy is about to enter a disappointing phase, but not one that matters much to them.  In Britain, only adults aged over about 60 will remember how stagflation plays out in real life. 

Stagflation describes a period when the economy, well, stagnates while prices as a whole keep rising.  Unless wages rise to catch up, peoples’ incomes buy less.  In short, living standards fall.  If wages are increased quickly, unemployment rises as companies slim down their workforce.  Without sufficient economic growth, the government’s tax take shrinks.
A vicious circle begins.  Consumers and government alike struggle to meet their spending preferences. 

In Summer 1973, the global oil price was little over $3 per barrel.  By March 1974 it had risen to three times that amount. In the UK, wages were increasing at a double-digit rate while economic growth faltered.  Companies wrestled to cope with widespread unofficial strikes and eventually in May 1979 Callaghan’s Labour government was toppled.  Tumult preceding the ensuing election in 1979 heralded the dawn of Thatcherism. 

Since its arrival in 2019, Covid’s global impact on investment confidence has yet to prove as destructive as the oil crisis nearly 50 years ago.  In 1973, the UK stock market fell by a third; in the following year it more than halved.  Although the UK equity index doubled the next year, it took a further three years to recover its 1972 level. 

Until early this year there was little sign of consumer prices accelerating.  Lately however there have been huge increases across a broad range of prices, especially for energy.  The same trends are evident in America, as in some European economies.  Input prices for companies are soaring just when consumers were recovering their willingness to spend. Corporate prospects have been dimmed by a vicious cost squeeze.  Unless companies can extract more from their existing capacity, the result seems likely to be a new period of stagflation - rising consumer prices with insufficient growth to offset them. 

These trends have surfaced at a time when the fruits of globalisation have largely been plucked.  The market catalyst supplied by the initial digital revolution looks to be virtually exhausted.  The UK Chancellor has referred to the need for financial stringency.  If taken seriously, this will limit government scope for yet more palliative intervention. 

Government debt outstanding is already equivalent to the UK’s entire output in one year.  The Bank of England now owns a third of the available UK gilts, overseas investors another 27%.  Much more borrowing by the Government could sap overseas investors’ confidence. 

The supply of Europeans willing to fill the UK’s lower paid jobs has vanished.  Truck drivers’ wages are having to be rapidly increased to attract more trainees.  Existing Government caps on public workers’ pay are to be set aside if only to buy time.  Some among the UK Labour party are pressing for a 50% uplift in the national minimum wage.  Although Labour leadership resists this plea, pressure for catch-up settlements may gather further strength.  A recent edition of The Economist draws the wrong conclusion from a weakening of UK trade union structures since the 1970s.  Pressure for higher wages is not sourced only from trades unions’ bargaining power.  It flows from a broadly based popular sense of injustice done to lower paid workers.  There is a strong tide of sympathy for their plight, and it is not powered solely by traditional sources. 

Hard policy choices confront the leaders of the Western world.  To manage effectively they need to possess two qualities; demonstrable competence, and the ability to inspire trust.  In America, President Biden, decent man that he seems to be, has to restore the authority of his office lost to Trump’s bludgeoning nationalism.  Shambolic planning and execution of America’s abrupt withdrawal from Afghanistan has raised the competence question.  The UK Premier faces a more enduring problem.  Extravagant claims during and since the Brexit referendum have been followed by a threat to withdraw from a crucial agreement to which he lent his signature only nine months ago.  Rhetorical virtuosity will not compensate for trust so lost. 

Dilemmas posed by a potentially stagnating economy stem partly from deficiencies in the supply and production of goods and services.  Solutions to current problems facing Western economies call for statesmanship of a high order. Current UK policy consists of hosing down a few burning trees at the front of the plantation while the forest behind blazes unabated.  Representing this as the designated outcome of longer-term planning invites ridicule.

The UK’s predicament is not unique.  Consumer prices in America and Europe are rising too.  Post an exuberant recovery, Western economies may struggle to achieve much real growth as they enter the next phase.  However, the UK’s lack of productivity poses difficulties particular to this country.  The relatively laggard performance of the UK stock market over recent years attests as much.  A shortage of home-grown technology giants is not the only reason for the country’s underperformance. 

Equity markets in Europe and America have yet to react to the prospect of stagnation.  Even the most successful companies are susceptible to the risk of a fall in investors’ confidence.  During the world’s recent economic history, standard criteria of investment value have become virtually useless.  For a decade or more, central banks have been flooding the money markets with cash.  Interest rates have been forced down to depths hitherto unplumbed.  In consequence, asset prices including bonds and equities have soared.  Meanwhile, the true cost of servicing government borrowing has been suppressed. 

However, now that immediate economic catastrophe has been averted many central banks look set to reverse tack.  Interest rates are rising again.  The end of artificial pricing is in sight.  Policy reversal looms in the UK as elsewhere.  Investors face the dismantling of a structure that has boosted their returns for more than a decade. 

For broadly similar reasons, American investors face a similar reversal of monetary policy.  They also have to contend with a potential devaluation of much of the US technology sector where stock prices have been boosted to the outer edge of reason. 

So much for the mounting difficulties.  Yet however dark the prospects may look, prudent investors must also weigh the countervailing factors.  Extreme negativism can be as costly for investors as any other mistake. 

Older readers will need no reminder that in 1974-75 a stricken UK equity market doubled within a year of hitting bottom.  Failure to anticipate a reversing tide of more positive sentiment damages potential returns as readily as failure to foresee the storm.  It is notoriously hard for investors to exercise a contrarian assessment when panic seizes markets. Yes, during turbulent times investors are wise to seek ways of avoiding the worst of any immediate downdraft.  But they must also be alert to hinge factors that may open up a brighter outlook.  What are these? 

Firstly, many of the factors underlying our concerns are widely recognised and therefore at least partly discounted in current market prices.  Investment expectations shared with the prevailing consensus generally prove disappointing.

Secondly, if markets threatened to crumble, the financial authorities could choose to intervene directly to support them. Improbable as that might seem to UK investors, central banks in Japan, Hong Kong and Switzerland have at various times resorted to such an expedient to stabilise markets.  When stability becomes the overwhelming priority, normal constraints may be abandoned. 

More broadly, investors need to remember that countless people living and working outside our little financial bubble are striving endlessly to make things better for all of us, to help make companies prosper, to restore economies to sustainable growth.  Human ingenuity and personal ambition are an indestructible source of surprise and reassurance. We need only recall the marvel wrought recently by Oxford’s vaccinologists.  Stagflation or not, it would be a big mistake to under-estimate humans’ undying capacity to improve outcomes for all stakeholders.  That truth underlies the simple fact that, over time, equity markets tend to go up, not down. 

Any conclusion from this scan of contending possibilities can only reaffirm the worth of a sensitively balanced approach to investment management.  Construction of such a balance lies at the heart of our work for clients.  It has done so for this past thirty-four years.

 

1st November 2021

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