Investment Strategy

Stagflation is not here to ruin our economy once again. Here’s why.

Oct 19, 2021

Current fears appear overblown. Yes, inflation is rising. But we believe it will remain at a manageable rate.

Joe Seydl, Senior Markets Economist
Pieter Clerger, Associate Markets Economist

The last time the United States faced a major period of stagflation was in the 1970s—and it wasn’t pretty. The economy was a mess, there were widespread food and energy shortages, and interest rates were soaring due to unhinged inflation expectations. Investors who sold risk assets, such as stocks and corporate bonds, to buy gold and other inflation investment hedges were rewarded.

Fast forward to 2021, and fears abound that the U.S. economy may be repeating a similar stagflation cycle—a difficult one-two punch of rising inflation and economic stagnation. After all, product shortages have emerged across numerous sectors, driving prices sharply higher.

For example, after trending sideways for about 25 years, the average automobile price has spiked up by more than 20% since the pandemic began in early 2020. Meanwhile, risk assets have continued their impressive run, with the U.S. stock market (adjusted for inflation) up roughly 30% over the same period.

Is the auto sector the proverbial “canary in the coal mine” when it comes to a 1970s redux? Should investors consider selling risk assets to buy inflation hedges such as gold with the expectation that stagflation appears to be just around the corner?

No! In reality, the U.S. economy in 2021 bears little resemblance to the 1970s upon a careful review of the data. Here are three reasons why.

Every Econ 101 student learns that prices can go up in the short run as a result of either negative supply shocks or positive demand shocks. In the 1970s, it was a negative supply shock: OPEC cornered the oil market and instituted an embargo, sending real oil prices up 150% at the end of 1973. A second oil shock then hit in 1979 as a result of the Iran hostage crisis, sending real oil prices up another roughly 130%. In addition, this all happened at a time when the U.S. economy’s “oil intensity”—the number of oil barrels consumed per unit of real GDP—was extremely elevated (it has since fallen by more than 70%).

The oil price shocks of the 1970s occurred during a period of elevated oil intensity

Source: Energy Information Administration/Bureau of Economic Analysis as of Q2 2021
The oil intensity of the U.S. economy continues to fall. This line graph shows the oil intensity of the U.S. economy (measured as barrels of oil per unit of GDP, indexed 1970 = 100) from 1950 to present. As shown in the chart, the oil intensity of the U.S. economy has dropped dramatically to almost a third of its high levels in the 1970s.

In our view, today’s inflation spikes are not a result of a negative supply shock, but rather from stronger-than-expected demand, which rapidly depleted inventories after catching many producers flatfooted. How can we say with confidence that demand, rather than supply, is in the driver’s seat? Look at profits and productivity.

A negative supply shock implies a contraction in corporate profitability and a slowdown in economy-wide productivity growth, which is how the data played out in the 1970s. Today, we are seeing the opposite: Corporate profitability has soared, coinciding with an acceleration in aggregate productivity.

Unlike in the 1970s, profitability and productivity have been on the rise

Labor productivity is calculated by dividing real final sales to private domestic purchasers by average weekly hours of all private production and non-supervisory employees. Corporate margins defined as before-tax corporate profit as a % of potential GDP. Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Congressional Budget Office as of Q2 2021
One significant juxtaposition to the stagflationary 1970s is that today corporate profit margins and labor productivity are up. This line graph shows corporate profit margins (measured as before-tax corporate profits as a % of potential GDP) and the rolling 5 year annualized growth rate of labor productivity (calculated by dividing real final sales to private domestic purchasers by average weekly hours of all private production & non-supervisory employees). Both measures continue to rise post-pandemic (and are above the levels seen immediately pre-pandemic), while these measures fell during the 1970s.

This rise in corporate profitability is also not unique to the United States; it’s a global development, broadly evident in the eurozone, Japan and across emerging markets (excluding China). 1

One issue to keep in mind is that, in principle, inflation could still become a problem if demand shocks are so extreme that they alter longer-term inflation expectations. But is there any evidence of this? Not really. Longer-term inflation expectations have ticked up, but not by much. According to one measure from the Survey of Professional Forecasters, 10-year-ahead median annual expected CPI inflation has increased by only about 25 basis points since 2019. 2

Despite recent price increases, long-term inflation expectations remain relatively muted

Source: Federal Reserve Bank of Philadelphia as of Q3 2021
This line graph shows the median value of forecasted annual average inflation over the next ten years from the Federal Reserve Bank of Philadelphia’s survey of professional forecasters. This is a measure of longer term inflation expectations. As show, inflation expectations have come down significantly over the last 30 years and today still remain low relative to history.

If the dynamics of stagflation aren’t playing out in the macro data, then why does it remain a prevailing concern for so many investors? According to Bloomberg, the number of news articles mentioning stagflation has soared, currently up more than 300% since 2019.

We think a main reason for this may be that too many investors are likely incorrectly reasoning from one sector to the broader macro-economy. More specifically, it appears there has been a micro bout of stagflation underway in the auto sector due to the global shortage of semiconductors.

However, in the U.S. consumer basket of goods and services, the auto sector is the only area where price growth has exceeded real spending year-to-date. Further, auto spending does not make up a large portion of the U.S. consumption basket, at only about 3.5% prior to the pandemic.

Source: J.P. Morgan Private Bank, Haver, as of August 31, 2021
This bar chart shows the year to date growth in real spending versus price change/growth of various consumer items. As shown, for all items except motor vehicles, real spending growth has outpaced price increases. However, for motor vehicles, the increase in prices has outpaced the growth in spending on the item (which is in fact negative year to date). This is a situation where demand destruction is present.

In other words, the global semiconductor shortage is an issue, but one we see more of as a micro issue that is not likely to push the economy as a whole into a 1970s-style stagflation trap. Plus, the light at the end of the tunnel for the semiconductor shortage appears to be finally in sight. Our Chairman of Market and Investment Strategy, Michael Cembalest, has noted that the semiconductor shortage is likely to ease by the middle of next year due to the flood of money entering the sector to expand production capacity (see Dude, Where’s My Stuff?). 3

The bottom line for investors is that stagflation fears are likely overblown right now, and we are not recommending a broad de-risking of multi-asset investment portfolios for fear of a 1970s repeat. In addition, inflation hedges such as gold and Treasury Inflation-Protected Securities (TIPS) do not look particularly attractive to us, especially from a valuation perspective. 4

We have said before that we think the economic cycle of the 2020s will look and feel more like the 1990s productivity boom than the 1970s (see Will the U.S. economic recovery reprise the ’90s surge?).  If this core view turns out to be correct, the setup for inflation hedge assets such as gold won’t be that favorable.

So look past the headlines and focus on the underlying data for a clearer inflationary and economic picture. Your J.P. Morgan team can offer you more insights into how the current environment and investment outlook are shaping risk and return potential in the context of your specific situation and financial objectives.

1 Profitability in China’s corporate sector has weakened this year amid the government’s regulatory crackdown on sectors such as for-profit education, fintech and property developers.

2 There are, of course, many other measures of inflation expectations, but they all appear to be telling a similar story in that longer-term inflation expectations do not appear to have changed much in the last year. We prefer the SPF measure referenced above, given its long data history, back to the late 1970s.

3 Additionally, the global containership shortage, which has caused freight rates to skyrocket, also appears to be overstated. The containership shortage has probably lifted the U.S. consumer inflation rate by around 35 basis points (See: Paul Krugman, August 12, 2021, “Expensive Boxes,” krugmantoday.com), which is not an especially large impact. For comparison, auto inflation at its peak in June was contributing about 150 basis points to the U.S. consumer inflation rate. 

4 Tactically speaking. From a more strategic or structural perspective, these assets may have a role to play in multi-asset portfolios, depending on an investor’s long-term investment objectives. 

All market and economic data as of October 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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