In his book, ‘The Black Swan’, Nassim Nicholas Taleb explores our inability to grasp randomness, particularly when it comes to significant market deviations and the difficulty of predicting specific events. History does not always exactly repeat itself and the biggest events are usually not entirely predictable. However, markets have been shown to be cyclical, whether it be the commodity cycle, long-term debt cycle or annual market seasonality events. So, what can we learn from the past given the current market conditions?
TS Imagine provides a stress testing risk module as part of its suite of risk products. This module includes native historical scenarios that can be customized to meet specific needs. These scenarios are based on past decades, allowing for a comparison with the current market environment. The resulting scenarios are then utilized as inputs into the engine for further analysis. Below we put this functionality to the test, building specific scenarios from previous events.
The Inflation Deflation Cycle of the 70’s-80’s
In our previous blog post, we examined the current macro situation and similarities to the 1940s in terms of high debt and inflation with multiple peaks. However, this isn’t the only period of history from which we can gain insights. Indeed, there is much to learn about the modern effects of the Dollar Reserve Currency and Fed actions from the late 1970s.
When we break it down, there are two main sources to inflation. One is Supply, or Cost Push Inflation – which we are currently witnessing with global energy shortages, the war in Ukraine and how this affects exports. The second is Demand, or Demand Pull Inflation, which mostly occurs when consumers believe that prices will go up and therefore buy in advance of these price increases – in turn causing shortages and pushing prices up.
In the 1970s, we witnessed both. On the supply side, the Arab-Israeli war of 1973 and the Arab Oil Embargo of 1973-74 caused a 300% surge in oil prices. Gerald Ford and Alan Greenspan looked to tackle this with their Whip Inflation Now (WIN) program – encouraging the public, at a grassroots level, to increase personal savings and reduce their spending habits. A severe recession followed in 1974.
| The earlier part of the 1970s underscored how supply chain issues can be a significant source of inflation, but this can also be followed by deflation where prices decline after a recession. However, if these supply chain issues are not fixed, inflation can quickly come back – as it did in the latter part of the 1970s – and this time on the demand side. At this point, Volcker crushed inflation by raising interest rates to 20%. |  |
So, how does this compare to today? The supply side impact is clearer with the impact of deglobalisation and current supply chain issues. However, there is little show on the demand side yet. Perhaps Powell has tried to learn from Volcker ,getting ahead of it by raising rates earlier. With the Fed unable to solve the supply issue, all they can do is raise rates and look to crush demand. However, by crushing demand a significant amount to affect the current supply side constraints, this may instead invoke a deflationary impact by way of a deep recession before making any material impact.
With a looming recession, the Fed does not have many tools to fight deflation other than their control over inflation through interest rates. This will likely lead to further quantitative easing and a continued increase to the Fed’s balance sheet. Knowing how rate increases have broken the banking system within the last year, the Fed may be weary of attempting to repeat this same method. This may instead lead to running negative real rates for a considerable period and allowing an overall debasement of the currency.
During currency debasement, hard assets increase in demand and price (e.g. equities, real estate, gold, bitcoin). For the most liquid of these, governments may introduce measures to curtail flight to safety. For example, in 1933, after seizing all the public’s gold, Franklin D. Roosevelt closed every bank in America and devalued the dollar against gold (from $20 to $35 an ounce). However, in a FIAT currency system, with no gold fix to break, the chokeholds for escape may be harder to apply.
Outside of the US, the 1980s were like the Great Depression for emerging markets. Gross Domestic Product (GDP) was often reduced by 10-20% more than in developed countries. When Volcker raised the cost of debt to solve America’s domestic problem, this had knock on effects for these countries which, in turn, required the IMF to step in with the Money Bank. The Mexico crisis of 1982 was equivalent to a “Lehman moment” for the emerging debt crisis.
For an example of how to use TS Imagine’s stress test engine we will look at an inflationary period with negative real rates and currency debasement. This will mimic the demand-pull inflation that occurred shortly after the fall of the cost-push inflation due to rate rises in the 1970s, but without a subsequent set of rate rises able to meet the secondary inflation burst. We could build risk factors as follows:
- Inflation Yields increasing by 500bps (USD-CPI” predictive shock)
- US Dollar Decreasing by 5% (“USD” global shift)
- Equities rallying by 20% (“.SPX” predictive shock)
- Gold rising by 30% (“GCc1”, predictive)
- Crypto rising by 100% (“.BTC”, predictive)
For more information on how we build these stress tests and the flexibility in our input model for the risk factors please contact a TS Imagine expert and learn more about TS Imagine’s risk management software offerings.