Global markets: Lessons from half a century ago

04 November 2022

Applying Twain’s observation to today’s complex array of market challenges, we decided to look back to the 1970s – a time of stagflation, weak growth, and high oil prices - to see what economic lessons we can glean from the past to help us better navigate tomorrow.

RECORD MARKET DECLINES

The first half of 2022 saw the largest absolute decline in asset prices in history, with global bonds and equities collectively losing US$31 trillion in value and cryptocurrencies shedding US$1.5 trillion. Compare this to the global financial crisis in 2008 where US$7 trillion was wiped off the value of global bonds and equities.

The Standard and Poor’s 500 (S&P 500) entered a bear market – a sustained, market-wide downturn of at least 20% – with its worst half since 1970, losing 21%, while the Dow Jones Industrial Average also posted its worst half since 1962. Global bonds also had their worst start since 1865, with the previous record decline occurring after the First World War.

United States (US) government bonds were down 10% and US investment grade bonds lost 11%, their worst performance on record.

The star performer of the previous year, the Nasdaq was down by approximately 30% – after gaining 27% in 2021 – while global equities declined by more than 20% in US dollar terms. The reasons for the change in sentiment can be largely attributed to the change in stance by global central banks and the war between Russia and Ukraine. The war has pushed up inflation around the world, creating a vicious cycle of interest rate hikes as central banks scramble to tame inflationary impulses, just as global growth slows.

THE IMPACT OF OIL

US consumer sentiment indicators are back to depths last seen in the late 1970s. This is despite unemployment in the US remaining at lows of around 3.6% with the number of job openings remaining stubbornly high – a consequence of the ‘great resignation’. The reference to the 1970s is, therefore, apt given that the era was characterised by stagflation – a unique period during which unemployment and inflation are high but economic growth stalls. Stagflation was, in turn, driven in part by two severe oil shocks.

At the time of writing, US consumers were paying more than US$5 per litre at the pump (and, here in South Africa, the figure was above R25 per litre). Today, the erosion of spending power caused by rampant inflation has become the main driver of negative consumer sentiment.

REWIND HALF A CENTURY

The 1970s saw a shift in power to the Organisation of Petroleum Exporting Countries (OPEC), from the previous cartel of seven oil producers. Over time, the five founding members of OPEC (Iran, Iraq, Kuwait, Saudi Arabia and Venezuela) were able to demand a bigger share of the price from the foreign companies to whom they had granted concessions. Rising demand for oil and constrained supply from the US allowed oil-producing countries to push up oil prices and tax the foreign companies exploiting their oil fields.

The surprise attack on Israel by Egypt and Syria on 9 October 1973 (the Jewish holy day of Yom Kippur), followed by aerial attacks by the Israelis on Syrian export terminals, led to a sudden disruption in the oil supply. To punish Israel’s Western allies, OPEC decided to lift the oil price by 70% to US$5 per barrel and cut production to pressure Israeli forces to depart from territory they had seized after the 1967 war. The Saudis also banned all oil exports to the US due to its support for Israel. With the embargo in place, OPEC pushed prices up fourfold to US$12/barrel. As Figure 2 shows, there was more than a fourfold increase in oil prices in 1973-74 and a halving of the S&P 500.

Source: Bloomberg

Figure 2: The oil price compared with the S&P 500 in 1973-74

Source: Bloomberg

Given the current approach by some European countries, and the United Kingdom (UK), to use price controls to shield households from the spike in energy prices, it is interesting to reflect on the effectiveness of the price control measures imposed by the US administration in the 1970s. These measures backfired for the Americans as the price caps discouraged US oil production. They also led to shortages at the pump as the artificially lower prices only served to stimulate consumption.

Figure 3: The federal funds rate and us inflation between 1978 and 1982

Source: Bloomberg

The US Federal Reserve (Fed), under Arthur Burns, was reluctant to fight cost-push inflation by using monetary policy. The US experienced stagflation in 1974-75 as the economy went backwards and inflation remained persistently high. The S&P 500 also halved over the 1973-74 period. With inflation breaching double-digit levels in 1979, then US President Jimmy Carter appointed the hawkish Paul Volcker as Fed governor. Volcker led the war on inflation by hiking rates from 7% to 19% and driving inflation down from 13% to 4% in 1982 (see Figure 3). This move, however, came at a great cost, with unemployment rising to 11% and the US plunging into a prolonged recession in 1982. The S&P 500 fell by a third over the 1981-82 period.

CENTRAL BANK HIKING CYCLE

In moves reminiscent of the 1980s, the Fed unleashed a jumbo rate hike of 75 basis points in June 2022 – the highest rate hike since 1994 – to combat rampant US inflation, which is at 40-year highs. This was followed by two 75 basis points hikes in July and September. With inflation showing no sign of retreating, the expected Fed pivot to a softer stance at the beginning of 2023 is now a remote possibility with another 125-150 basis points of hikes expected.

Current Fed chairman, Jerome Powell, is now on track to go into the history books as the ‘Volcker of our times’ by fighting inflation at the cost of jobs and economic growth. The one difference is that the US economy is now a lot more leveraged than it was in the 1970s and a sharp increase in real rates will have a severe impact both on corporates and on households (see Figure 4).

If the 1970s are anything to go by, there is a high chance that the Fed will now risk plunging the economy into recession to wring out inflation. With the S&P down just over 20% year-to-date and corporate earnings likely to come under pressure, our multi-asset portfolios remain cautiously positioned.

This is especially prudent in light of the grim scenario that played out half a century ago, which provides a glimpse into what could yet unfold.

Back in 1848, Austrian aristocrat Klemens Wenzel Fürst von Metternich commented that: “When France sneezes, the whole of Europe catches a cold." Today, this observation is frequently applied to the US economy with the codicil that “the whole world is likely to catch a cold”.

“With inflation showing no sign of retreating, the expected Fed pivot to a softer stance at the beginning of 2023 is now a remote possibility with another 125-150 basis points of hikes expected”

 

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