The Seventies are not coming back
Real rate policies created looser conditions in the 1970s
Although today’s monetary policy is unprecedented in real terms, rates paid in aggregate by the government, corporates, consumers and mortgage-holders were actually far lower in the 1970s (Figure 1).
Figure 1: In real terms, monetary policy created looser financial conditions in the 1970s1
While today’s environment is often compared to the 1970s, we believe policy at the time led to looser financial conditions over a much longer period, creating far greater inflation potential.
1970s: loosest financial conditions ever?
The stagflation crisis was an (then unprecedented) inflationary recession in the 1970s.
It was sparked by policy stimulus (enacted to help finance an escalation of the Vietnam War and ‘Great Society’ social programs), US dollar devaluation (as the era of fully free-floating currencies first took hold) and painful oil shortages (a consequence of the Yom Kippur War).
The colossal ‘policy error’
Policymakers had no consensus playbook for stagflation. They stimulated the economy to reduce unemployment (the ‘Keynesian’ framework for combating deflationary depressions).
This led to a wage-price spiral as re-employed workers (backed by more powerful unions across the labor market) demanded inflation-adjusted wages, in turn pushing inflation higher, spurring further wage negotiations. This cycle eventually sent inflation to a high of ~15% (Figure 2).
Figure 2: A stagflation timeline2
Eventually, the Federal Reserve broke this feedback loop by reversing course and aggressively raising rates. This laid the foundations for its current dual mandate, to target employment and inflation.
Inflation was sticky in the 1970s, but appears transitory today
In the 1970s, the wage-price feedback loop meant rising inflation was partly self-sustaining, requiring a sharp policy reversal to break.
However, today’s inflation is largely the result of a post-pandemic normalization – a one-time event unlike the years of build-up seen in the 1970s. We expect inflation to fall without a major policy reversal.
This is reflected by the difference in ‘sticky’ inflation (i.e. prices that are slower to change, like annual rents) and ‘flexible’ inflation (like daily gasoline prices) then and now (Figure 3).
Figure 3: CPI was sticky in the 1970s, but transitory today3
Demographics was another structural inflation driver in the 1970s. The baby boomer generation came of age and entered the workforce, resulting in rising consumer demand.
However, these trends are now in reverse as the baby boomer generation enters retirement. Other post-‘70s secular trends such as the hyper-globalization of trade and technological change have also moved us firmly into a secular disinflationary regime (see The Inflation Debate is Overheating).
Assets that have historically performed well through transitory inflation
Inflation, when a result of GDP growth, tends to be positive for revenues and profits. This is one reason why corporate bonds consistently outperformed during bouts of inflation since 1998.
Furthermore, given the yield advantage most corporates have over TIPS, corporates tend to outperform inflation by more than TIPS and underperform inflation by less (Table 1).
Table 1: Corporate bonds a better inflation hedge than TIPS?4
|Asset outperforms inflation in a calendar year||Asset underperforms inflation in a calendar year|
|Frequency of outperformance||Average percentage outperformance||Frequency of underperformance||Average performance of underperformance|
|US corporate bonds||73.9%||6.8%||26.1%||-3.9%|
|Develop ex-US equities||60.9%||18.8%||39.1%||-16.2%|
What if inflation proves to be more persistent?
We stress tested the impact of a hypothetical inflation shock on credit market fundamentals.
We assumed inflation would lead to an interest rate shock of an additional +100bp beyond current market pricing over 2021, then remaining at those levels above forwards for four years5. This is essentially the equivalent to 10-year yields moving from ~1.5% today to 3%6. We held all other assumptions (including GDP) constant.
Assuming $500bn of net issuance in 2021 and 2022 and $750bn per year thereafter7, we find a +2% rate shock would only take interest costs (as a % of GDP) back to pre-COVID levels by the end of 2025 (Figure 5).
Figure 4: Corporate interest costs to GDP will potentially remain low even amid a +100bps rate shock8
Debt levels (relative to GDP) will likely decline this year and next as growth rebounds, pushing down corporate interest expenses as a share of GDP, assuming no rate shock9. Indeed, even if rates rose 100bp beyond the forwards, interest expense would only slowly rise to 2.4% of GDP, similar to levels that persisted in 2016. If GDP were to rise under an inflation shock, the impact would be more muted still.
Nonetheless, a rate shock closer to +200bp above forward pricing would likely cause some corporate retrenching, but we do not anticipate it precipitating a default cycle without a further move higher. While a rate move up of 100bps is conceivable, a move of +200bp above forwards appears remote to us. In such as scenario, we believe the Fed would act to calm markets that would trigger a sell-off in risk assets.
Playing inflation concerns in credit
Consider at-risk sectors but do not just exclude them
In an environment in which inflation rises as a result of improving economic growth, we expect some sectors would be more resilient than others, creating opportunities for active managers (Figure 5).
Table 2: Certain sectors would be potentially more resilient to rate shocks10
|Autos||Revenues||Low||Consumer confidence and employment correlates better with auto sales than borrowing costs|
|Healthcare||Interest costs||Low||Low leverage sector with non-cyclical demand patterns|
|Technology||Revenues||Low||Low leverage sector, but more discretionary businesses may see top-line risks (potentially greater implications for equity than fixed income investors)|
|Consumer sectors||Revenues||Low to moderate||Non-cyclical demand for consumer staples. Top-line challenges for consumer discretionary|
Although certain sectors would see greater margin pressure, strong issuers with high initial margins may be well-placed to absorb it. As such, we believe in considering the strongest, best-in-class issuers within sectors such as energy and utilities.
Shock absorbers will potentially provide opportunities to ‘buy the dips’
In general, we also continue to believe in ‘buying the dips’ as long as we view the risks as transitory, as inflation prints have the potential to spark bouts of volatility.
The Fed’s aggressive monetary policy has created a ‘wall of money’. Since 2020, the Fed has expanded its bond holdings by $3.7trn. This is ~$1.6trn higher than the net volume of bonds created in the Barclays Agg over the same period (Figure 5).
Figure 5: The Fed’s ‘wall of money’ is impacting financial assets rather than the real economy 11
We expect this ‘wall of money’ will make it more difficult for rates to rise, due to its potential shock-absorbing effect. It will equally increase the probability of a sharp reversal if rates were shocked higher as some of the excess liquidity comes in to buy the dip.
Furthermore, refinancing needs have fallen dramatically as corporates aggressively raised debt to build liquidity buffers, lock-in low yields and term out maturities since the start of the pandemic. ~70% of existing corporate debt carries fixed rate coupons and issuers with floating debt exposure tend to be partially hedged. In fact, rising inflation would cause the real cost of existing corporate debt to fall.
This further highlights to us that the other main difference between the 1970s and today is that the ‘inflation’ the Fed has created has and (potentially will continue to be in) financial assets rather than the real economy. This is a different era, the 1970s are not coming back.