Welcome to Finance and Fury. In this episode, we will be looking at the economy of the 1970s – looking at the share market correction that occurred and what contributed to this – the aim of this episode is to see if will we experience the same sort of market conditions, or if what we are dealing with is something completely different and have we have already seen the worst of it? Or if there might be worse to come – history doesn’t repeat exactly, but it often rhymes

Lots to go through – especially because there is never one cause for a recession or market decline –

  1. There is a support and resistance for gains and declines in markets – if you have too many negative events play out, the markets can bottom out, breaking through their support and the confidence that was holding a floor on the price of any asset has been shattered – one or two bits of bad news by themselves will not cause much of a negative return to the wider market –
    1. As an example – just higher than expected energy prices on their own can be corrected by the market relatively quickly and won’t impact the wider economy or financial markets too badly – sure, specific companies, like transportation companies may suffer, but the wider market won’t
    2. but now combine this higher energy cost input with cuts to supply chains, disrupting supply, this can lead to worse levels of inflation than either event could provide on their own – then, there is a massive increase in costs of living
    3. To combat this inflation – central banks increase interest rates and the cost of housing also goes up – either in the form of covering interest repayments on a mortgage, or increases in rent due to the costs being passed on by the landlord
    4. This makes a bad situation worse for the everyday individual – cashflow will start to struggle as you have higher levels of costs of living across the board – If increases in interest rates can stem the inflation of goods and create deflation, then then the costs of housing can be offset by cheaper goods – But if inflation isn’t controlled by the increase in the interest rates, then this can lead to a catalyst for a collapse due to lower economic output due to lower levels of spending in consumption, making up the lion share of our GDP – and for CBs to potentially increase interest rates even more – making the situation worse
  2. What drives CBs and economists’ policy making decision are three big macroeconomic variables – GDP, unemployment, and inflation – so these are some of the metrics we will be looking at today
    1. They each play their part in telling the story about how the economy is doing – GDP gives an idea about what the broader economy is doing, unemployment shows the level of vacancies in the workforce, and inflation measures the movement of prices of the things people consume
    2. Until the 1970s – many economists believed that there was a stable inverse relationship between inflation and unemployment – in other words, they believed that inflation was tolerable and, in a way, ideal in an economy because it meant the economy was growing and unemployment would be at low levels
      1. This is based off the belief that an increase in the demand for goods drives up prices, which in turn encourages firms to expand and hire additional employees, creating additional demand throughout the economy
      2. Therefore, inflation is meant to be great for the economy – but at what level? Well, this is where this theory got proven wrong in the 1970s

Before we get there – what happened in the 1960s?

  1. Most developed countries had recovered from WW2, opening up their production capacity as well as opening up more avenues for international trade –
    1. This has two effects, increasing access to goods and services with foreign nations as well as nations starting to take advantage of their competitive advantages –
    2. Manufacturers were opening factories in foreign countries to take advantage of cheap labour – through this process, the prices of goods were also reducing
    3. you also saw the start of developments in computers – contributing to the increasingly widespread use of computerized technology in business
    4. Through all of this – seeing increases in demand for labour in improvised countries and cheaper goods, poverty had been seriously reduced world wide –
  2. When it came to financial markets – increasing numbers of people were starting to own shares and, between 1962 and 1968, share market growth around the world outperformed the gains seen in the bull market of the 1920s
  3. The world and economy was progressing – but was constrained in terms of monetary expansion, with the exemption of the US due to the Brenton Woods agreement – Which was increasing their money base above what was agreed upon – they needed to cover the costs of the massively increased welfare and government employment expenses under the Great Society program – on top of funding the Vietnam war – Nations like France were worried about this – so wanted to withdraw their gold reserves and sent a warship to New York to do so – you also had the IMF try to introduce the SDR to replace the USD as the currency nations were pegged to – But the US under Nixon beat them too it

Enter 1970s – So what exactly happened during this period, and why was it so damaging? Like any major correction, there was a combination of different factors, being: the detethering of the currency from a physically backed asset (gold), inflation, price controls, increasing interest rates and an energy shock

  1. The first block pulled out of the Jenga tower was the floating of fiat currency – untethering the dollar from gold
    1. This is also known as the Nixon Shock – which saw the breakup of the Bretton Woods system – all of a sudden money was not constrained by a physical asset that it had to be pegged to, being gold – the US was meant to hold gold reserves for every dollar that they issued – other nations would then peg their currency to the dollar – so when the world went off a pegged system and countries went onto their own fiat currency for the first time in modern history – there was naturally many teething issues – this start to fuel high inflation during the ’70s
  2. The second shock to the economy was the energy turmoil – two oil crises has some part in helping to push inflation to record highs
    1. In October 1973, Arab members of OPEC placed an embargo on the U.S. for its support of Israel in the Yom Kippur War – Now this is before Henry Kissinger helped give birth to the petrodollar with these Arab OPEC nations in 1975 – so this embargo saw oil prices go from $23 per barrel to $62 in a matter of days – seeing an almost 3 fold increase was a massive shock – A second oil shock in 1979 led to a decrease in Iranian oiloutput due to the Iranian Revolution – so prices reached $138 at its peak in 1979 – so even without adjusting for inflation – oil was more expensive in 1979 than today showing the magnitude of pricing inflation for transportation costs alone
  3. This helped to usher in the third shock – being turbulent inflation – Under a system where money is pegged to some physical backing asset – and things are stable with little central bank intervention – inflation rates remain relatively low – For the first half of the 1960s – inflation was around 1.5% – then the US started expanding their money supply beyond their gold base – this is where inflation increased, but stayed below 5% at the end of the decade – reached a lower point at the end of 3% in 1971 – but by 1974 it was running at double digits, being 11% – by the start of 1980 it was around 13.5% after seeing a decline back to 6% in 1976 before shooting up – this is partially due to the next major shock to the economy
  4. As what didn’t help matters – even though they thought it might were governments stepping in to enact price controls
    1. The Nixon administration ended up introducing wage and price controls from 1971 to 1974, but this only slowed down prices while increasing food and energy shortages – then when they were removed prices increased massively again due to the government created shortage of goods and services
    2. Price controls always fail to achieve their desired effect – happens every time – in western or socialist countries – due to markets determining the appropriate price, if you have a government step in a set a floor for what a good can be sold for – all that happens is that if this price is below the costs of production, people simply stop producing the good – so the supply shrinks massively, and you end up with noting to sell, even if it might be cheap – due to price controls, you can see energy shortages, which is what happened in the 70s, where fuel distributors just closed down, making the shortages worse, or you saw empty the shelves of supermarkets.
  5. In the end, the last thing that shocked the markets were the increase of interest rates – with an aim to combat inflation, the Fed began to raise interest rates in 1977 – well after the worst of the initial market declines had occurred – In Aus – the worst years of the 1970s for the share market were 1973 and 1974 – resulting in losses of around 24% each year consecutively – But this increase of interest rates started to cause the economy to tip into recession in the 1980s
    1. This is due to inflation continuing to rise despite the increases of interest rates – which prompted the Fed Chairman Paul Volcker, as well as other CBS around the world – to continue to raise rates. The U.S. entered a recession that lasted from July 1981 to November 1982, with unemployment peaking at almost 11%
    2. However, year-over-year inflation ended up dipping under 5 percent near the end of this period, with unemployment eventually scaling back

This brings us to today – where do we stand in comparison – well, the good news is that we do have a decent shot of escaping a re-run of the 1970s style stagflation – where there was little GDP growth and high inflation – the key will be if interest rate increases and what the ceasing of easy money will have any effect on inflation

  1. We have three and a half of these five shocks to the economy – I say half because whilst we don’t have the same level of price controls leading to a supply shortage, we have had control leading to supply disruptions
    1. We don’t have the new monetary system – that was such a radical change – Digital central bank currencies are on the way – but they are not here yet
  2. But what we do have is high inflation, increases of energy costs and increasing interest rates – these three alone can, and evidently have corrected prices – particularly interest rates in response to inflation
    1. I’ve covered this over the last few years, but higher inflation really affects growth companies – why large tech companies in the US have suffered the worst
    2. The thing that can save markets with increases of interest rates in response to inflation is decent GDP and unemployment figures –
      1. In the US GDP growth is sliding back – US has seen a dip to -1.4% as an annualised estimate as US economy contracted – the issues is not the negative GDP, but that this was well below the market forecasts of a 1.1% expansion – the Aus GDP growth was above the forecast, where we reached 3.4%, above the expectation of 3% – we have not seen the same declines as the US have had on their index – we are beating expectations
      2. Unemployment figures on the other hand look at lot better in the US – back to 3.6% – down from the massive 15% reached in 2020 with the shutdowns – whether this is just a lack of people looking for work, not being included – well this is probably close to the truth, as the participation rate went from over 63% to about 62% today – so not everyone who lost their job has returned to the workforce
    3. Inflation rates and interest responses when compared to levels in 1970s to 1974 compared to now
      1. This has not hit the same levels as the 1970s and 80s – It may reach there – but it hasn’t yet
      2. The major issue will be the increase of interest rates in response to inflation – as the Volker increase would be suicide – as what is different are the Debt levels – household debt to GDP levels are double what they were in the 70s in the US and three times what they were in Australia – we are currently sitting at 120% household Debt to GDP – where in the 1980s were at 40% – higher sensitivity to interest rate movements – so the same levels of 17% mortgage rates are very very unlikely to be seen

In summary – This sort of correction that we are going through is more of a known known – prices are adjusting in markets to the increases in interest rates

  1. Where things can get worse – Central banks increase interest rates and it has little to no effect on inflation – this could lead to the hawkish side to further increase interest rates –
  2. The economy cannot afford the same levels that were reached in the 80s – at 16% – The average mortgage was about 9 times smaller, making up a household to income ratio of less than half of what it does today
  3. Hopefully this is not another event like GFC, where there were massive levels of price collapses – but that was due to the financial system – not the macro economy at large – this decline may be more protracted, taking a year or more to fix itself – but the hope is that central bank policy errors don’t take front and centre – but that is the risk to the economy and financial markets at this stage – the belief that they can help with inflation and they become hawkish and increase rates too much – just to the damage of the economy with no effect on inflation and hurting economic growth in the process
  4. I don’t think we will see a massive jump in interest rates – and what we are seeing in markets is the repricing of assets back to fair values under a higher interest rate environment where companies cannot issue debt at close to zero costs to fund their growth activities – but hey, its anyones guess what happens from here

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