Orlando, Florida — With prices rising and economic growth slowing, many investors are looking to the past in a bid to divine where US markets might be headed next. While the “stagflation” of the 1970s brings back memories, investors may want to revisit the mid-2000s instead.
In both periods energy prices, inflation expectations and bond yields rose, alongside anaemic growth and central banks moving towards tighter monetary policy. The mid-2000s were, however, far milder.
While all economic and market cycles are unique — none more so than the last 18 months of Covid recession, rebound and inflation caused by supply bottlenecks and shortages — the conditions that exist today are more akin to the ones that occurred in 2005.
Like 2005, US equity valuations are now gently falling. The S&P 12-month forward price-earnings ratio is now around 20.5, down from over 23 a year ago, mirroring the decline to 14 from 16 over the course of 2005.
That downward drift continued into 2006. Given that price-earnings ratios are still historically high, there is every reason to expect this trend extending into 2022, and potentially accelerating if guidance from third-quarter earnings is gloomy.
The S&P 500 experienced two mini-corrections in 2005, the first of 8% in March-April and then a 6% drawdown in September-October. The index just had its first 5% fall in almost a year and, according to nearly two-thirds of more than 600 market professionals recently surveyed by Deutsche Bank, a 5%-10% correction by year-end is in the cards.
Some analysts have started to point to the mid-2000s as a possible case study. Morgan Stanley’s Andrew Sheets wrote in a note on Sunday that 2005 was “an interesting, recent example of a stagflation scare after a mid-cycle transition”.
In some key respects, the inflation picture is more akin to 2005 than the 1970s, too.
Headline annual inflation is now just above 5%, the highest in 13 years, compared with a peak of just below 5%, a then 14-year high. There is no sign of the double-digit prints from the mid- and late 1970s, a period of a serious wage-price spiral.
Inflation of the 1970s is rightly associated with energy shocks and shortages. But in the mid-2000s, notable increases in oil and natural gas prices occurred and were key drivers behind the broader rise in consumer prices. Just like today.
Brent crude more than doubled to $65 a barrel by the end of 2005 from about $30 at the beginning of 2004. It has more than doubled in the last 18 months to $83 a barrel, and will test $100, according to a majority view in the Deutsche Bank survey of investors.
US natural gas futures recently hit a 12-year high above $5.565 per million British thermal units (mmBtu) after a near-40% spike in just six weeks. In July-August 2005, natgas prices surged around 50% to a still record high, just shy of $14/mmBtu.
There’s no doubt investors and policymakers must be vigilant as inflation expectations measured by break-evens rise across the curve towards May’s multiyear peaks. For the US five-year rate, that’s around 2.80%, and the last time it was above that level for more than a few days was in 2005.
Call it calm or complacency, but Wall Street appears relatively relaxed. The VIX index of implied volatility on the S&P 500 has mostly traded below 20 since March, suggesting equity markets are broadly comfortable with expected higher future levels of inflation, interest rates and bond yields.
As Morgan Stanley’s Sheets points out, inflation markets imply that price pressures will moderate over time, rather than spiral. In addition, nominal interest rates are low, and equity valuations are near all-time highs.
In the 1970s, the opposite of all that held true.
“If ‘stagflation’ means ‘the 1970s’, a time of wage-price spirals and high unemployment, this clearly isn’t it,” he said.