1970s stagflation? It’s the opposite

Prices have climbed around the world, with commodities prices surging and US inflation hitting a 13-year high. It’s the first time since the 1970s that a supply shock is the main culprit. This is where the comparison ends. There’s no risk of 1970s-style stagflation, in our view. Economic activity is increasing briskly and has room to run. We remain tactically pro-risk, but see a narrower path for risk assets to move higher as markets and policymakers could misread the price surge.

Chart of the week
Global industrial production (IP) and Brent crude oil prices

Source: BlackRock Investment Institute, with data from BEA, Netherlands Bureau for Economic Policy Analysis, Energy Information Administration. Chart year-over-year growth in global industrial production (IP) on the left and Brent crude oil prices on the right.

We have long held that inflation was one of the market’s most underappreciated risks.  Now it’s here. This year’s surge is primarily driven by a major supply shock:  the vaccine-driven restart of economic activity from the pandemic’s shutdowns. Producers have struggled to meet resurgent demand, clogged ports have increased shipping costs, and surging commodities have added to price pressures. These dynamics mark a sea change from the environment many of today’s investors know best: decades of low inflation on the back of deepening globalization and technological advances. The last time a major supply shock drove up inflation was in the 1970s, when an oil embargo by producers triggered a spike in oil prices. Today’s oil price surge naturally raises the question of whether the economy is headed for 1970s-style stagflation, a period of high inflation coupled with weak growth. We think not. In fact, the growth situation today is in many ways the 1970s turned on its head. Growth is increasing at a rapid clip, rather than stagnating, as the restart rolls on. The oil price surge is to be expected in this environment, in our view. As the chart shows, oil prices (the yellow line) have moved in line with the resurgence in economic activity (red).

Why is today’s picture different? First, the current pickup in inflation is driven by the restart, not rising energy prices. Supply capacity has been slow to come back online, resulting in bottlenecks and price pressures. Second, growth has room to run, we believe, with global activity well below its long-run potential. Supply will eventually rise to meet demand, instead of the 1970s experience of demand going down to meet supply. Third, resurgent activity is increasing demand for oil and driving prices higher. Again, this is the exact opposite of the 1970s, when higher oil prices harmed economic activity.

We expect the restart pressures to persist well into 2022 before eventually subsiding as near-term supply-demand imbalances ease. There are factors beyond the restart that could add to this persistence: the consolidation in the resources industry, capital discipline by producers, years of underinvestment in production capacity, and perhaps the shift to more sustainable energy sources. The series of shocks provide a glimpse of what a disorderly transition to a more sustainable world could look like, with a risk of commodities volatility jumping to other asset classes – and a resulting increase of risk premia across the board. This underscores our 2021 Outlook theme the Journey to net zero.

The risk is that markets and central banks misread the current shocks, leading to fast-rising inflation expectations or premature monetary tightening. We believe central banks with credible inflation frameworks will largely look through the restart price pressures – and avoid a premature tightening that hurts growth but does nothing to address the bottlenecks. We expect this to play out differently around the world, and could see central banks that worry about their handle on inflation expectations take a more hawkish approach than others.

 The bottom line: There are persistent inflationary forces at play today. We see the restart price pressures eventually resolving themselves, and believe central banks with credible policy frameworks will look through most of them. Our New nominal investment theme keeps us moderately pro-risk on a tactical basis, even as we see a narrower path for risk assets to move higher. The inflation spike could result in inflation expectations spiraling upward, central banks tightening policy prematurely - or markets pricing in either of these outcomes before they actually happen. We are underweight government bonds as we expect yields to gradually catch up to the reality of the strong restart. On a strategic horizon, we still see a shift to a moderately higher inflation regime amid structural cost pressures and the ongoing policy revolution – the unprecedented coordination between monetary and fiscal policy. This keeps us preferring inflation-protected securities over nominal bonds.

Assets in review
Selected asset performance, 2021 year-to-date and range

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of Oct. 15, 2021. Notes: The two ends of the bars show the lowest and highest returns at any point this year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in US dollars, and the rest in local currencies. Indexes or prices used are, in descending order: spot Brent crude, MSCI USA Index , MSCI Europe Index, ICE US Dollar Index (DXY), Bank of America Merrill Lynch Global High Yield Index, MSCI Emerging Markets Index, Refinitiv Datastream Italy 10-year benchmark government bond index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream US 10-year benchmark government bond index and spot gold.

The third-quarter corporate earnings season kicked off with strong results that were boosted by the powerful restart. Overall, S&P 500 profits are set to jump 26% on revenue growth of 14%, according to consensus estimates. The top item to watch:  signs of cost pressures. We view the recent yield backup as correcting a disconnect between the restart and low yield levels, rather than foreshadowing a more drastic yield rise.

Week ahead

Oct. 18 US Industrial Production; China retail sales
Oct. 19 US housing starts
Oct. 21 US Philly Fed Business Index; Euro area Consumer Confidence Flash
Oct. 22 US, UK, euro area and Japan Markit Flash PMIs

This week, we’re watching a slew of Purchasing Managers’ Indexes (PMIs) for a read-out on manufacturing bottlenecks and to gauge the strength of the restart of economic activity. A continued restart could pave the way for further labor market normalisation, while we expect supply chain frictions to ease as global manufacturing production and trade ramp up.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, October 2021

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, October 2021

Read details about our investment themes and more in our 2021 Global outlook.

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Sources: Bloomberg unless otherwise specified.

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