Markets & Research
Guess the year: The federal government is using deficit spending to pump massive amounts of money into the economy. Think you’ve got it? Here’s a hint: George Harrison had just released a solo album, and Jan Brady was exasperated by “Marcia, Marcia, Marcia.”
Yes, it was 1970. The U.S. had loosened its purse strings in a misbegotten attempt to goose economic growth. The tactic backfired spectacularly and touched off a yearslong spiral in consumer prices. The decade became notorious for long lines at gas stations and widely mocked WIN — “whip inflation now” — buttons. The inflation fever was broken only when the Federal Reserve pushed interest rates dramatically higher in the early ’80s, triggering an oppressive recession in the process.
Given that backdrop, it makes sense to wonder whether today’s accommodative monetary policy and ample government spending might threaten a replay, especially if a successful vaccine campaign leads to a burst of pent-up consumer spending. That concern may be especially acute for retirees, as well as endowments and foundations, which may be deeply sensitive to rising prices.
On the one hand, the economy today needs support, says Greg Singer, investment director at Capital Group Private Client Services. The coronavirus pandemic has caused scores of businesses to close and displaced millions of workers, so there is a deeper hole to fill than in the lead-up to the inflation crisis of the ’70s.
But that’s not to say concerns are misplaced. There are good reasons to be wary: If policymakers extend the stimulus too long, “the risk of inflation will rise in the intermediate term,” Singer warns.
The years 1970 and 2020 were both marked by economic downturns coming on the heels of yearslong expansions. A recession that began in late 1969 carried through most of 1970, while 2020 suffered a sharp pullback in February. However, the situations are similar only in the broadest of strokes.
The 1969 recession was relatively mild, while the COVID-19 pandemic was a gut punch whose impact is still being felt. And though the U.S. stock market recovered and posted new highs in 2020, other economic measures, chiefly unemployment and business activity, are still recovering. That’s in stark contrast to the early 1970s, which had generally good underlying figures.
“When inflation accelerated in the ’70s, we had strong labor markets and high levels of factory utilization,” Singer says. “Those conditions do not exist today.”
While unemployment was trending up in 1970, the year generally featured strong labor figures. The pre-inflationary period never came anywhere near the 14% unemployment the U.S. hit in the depths of 2020’s downturn. Similarly, factories had a bustling 88% capacity in 1973 and only rarely dipped below the low 80s throughout the decade. By contrast, factory capacity never broke above 79% in the 2010s and is now just under 78%. Utilization rates of 80% or higher are associated with accelerating inflation.
The federal spending at the start of the ’70s was going into a generally healthy and active economy. In comparison, today’s government stimulus is an important bridge to a post-pandemic world. It’s helping mitigate bankruptcies
and the risk of long-term structural unemployment. Pumping money into a decent economy wasn’t the only factor that led to the earlier era’s infamous “stagflation” — low growth paired with persistent inflation — but it was a major contributor.
Of course, the Fed’s current policies of ultralow interest rates, relaxed inflation targets and extensive bond buying aren’t without risks. Policymakers have to delicately thread this needle, Singer says, noting that too much stimulus could cause damage.
“Capital Group analysts are watching these factors closely,” he adds. “If the Fed does not pull back on its stimulus in an economic recovery, if loan growth begins to accelerate, that could raise the risk of inflation in the intermediate term.”
With that in mind, Singer examined a variety of assets and their historical returns during different periods of price changes. Commodities historically have shown the greatest inflation sensitivity, with returns that were higher when prices rapidly grew. Gold has historically done well in periods of deflation and extreme inflation. Critically, though, equities were the best choice in low- and modest-inflation periods and over the longer term. That’s partly because many companies can raise their prices and prevent inflation from eating into their profits.
Many of our equity portfolio managers are selectively investing in companies with natural inflation hedges. For example, custodian banks hold assets that can benefit from the rising interest rates that tend to accompany an inflation spike, but they lack the credit exposure of other commercial banks.
Still, considering the low outlook for inflation — the break-even rate for 10-year Treasury Inflation-Protected Securities, a common guide for inflation expectations, was just under 2% at the end of 2020 — most investors probably don’t need to change their asset allocation, Singer says.
“Adding inflation-defensive asset classes really only makes sense for people who are highly risk averse,” he says. “Even then, they should only be added at modest weights. There is a cost to inflation hedges. Those asset classes have historically had lower returns and higher volatility than equities. Additionally, gold prices have run up recently, so there’s a heightened risk that they could pull back if extreme scenarios don’t play out.”