What Investors Can Learn From the History of Inflation

After World War II, stocks did well despite bouts of inflation. But that only lasted until the mid-1960s. Returns for stocks and Treasurys then struggled until after the 1970s inflation was crushed.

One reason why stocks did well in the 1950s was that money flowed into the market as pension funds and other institutions bought equities for the first time, according to Ian Harnett, chief investment strategist at Absolute Strategy Research. That helped push down the so-called equity-risk premium, which measures the extra returns stock investors demand over government bonds for the risk of losing their money.

In the 1970s, the risk premium rose again and stocks underperformed when inflation took hold. The clues to why this happened are elsewhere in the economic backdrop. 

After the war, there were bouts of inflation, but the real economy grew strongly enough to keep up with price rises. Resources used for the war effort were put back into peacetime production. Then from the mid-1960s, a gap between real growth and the influence of inflation opened up. 

Richard Sylla, professor emeritus of economics at NYU Stern, who wrote a history of interest rates, characterizes the postwar inflation as prices catching up with reality after wartime price controls were lifted.

Things changed in the 1960s. Heavy government spending on the Vietnam War and President Lyndon Johnson’s Great Society programs met low interest rates. Money supply grew strongly and what Mr. Sylla calls the Great Inflation began. 

The economy overheated. First, the output gap, which measures the economy’s capacity to produce enough stuff in relation to the demand to consume it, went negative as demand outstripped supply.

Then, in the late 1960s excess demand turned into a long trend toward increasing oversupply. As inflation rose, the labor force grew and people demanded higher wages.

At the same time, the Federal Reserve became more influenced by politics:

Arthur Burns

chair of the Federal Reserve worked closely with Richard Nixon to help get him re-elected, Mr. Sylla said. 

The dollar’s value became volatile after President Nixon suspended the dollar’s convertibility into gold in 1971. This sounded the death knell for the Bretton Woods agreement, which had tied international currencies to each other. 

A more volatile dollar fed into higher import prices, which made inflation more volatile and uncertain. Uncertainty is bad for investors and that is one reason why the equity risk premium rose again—and stock market returns suffered. 

Then came the first oil-price shock, when many Arab countries blocked exports to the U.S. in protest at America’s backing of Israel.

Where are we today? We have a low equity risk premium, leaving stocks without much of a cushion against uncertainty. 

The government is determined to stimulate the economy and cut unemployment. But unlike the mid-1960s, the output gap hasn’t yet been closed. The Fed’s role is key. It has promised to let the economy run hot in its quest to hit full employment.

Overheating seems an uncertain prospect, especially if the recent rapid growth in the money supply quickly corrects to a much lower level as it did after the war.

One place investors have turned in the past are precious metals like gold. In the 1970s, the yellow metal provided very strong inflation adjusted returns. It was a non-factor in the postwar period, when gold trading was banned. 

Within the stock market, companies in cyclical industries, things like chemicals or mining companies, or airlines, performed better during the late 1970s and early 1980s than those in defensive industries, such as utilities or consumer staples like soap, food and tobacco. Since then, cyclical stocks have underperformed, if technology companies are excluded. Avoiding technology companies, or at least those that rely on low interest rates to make their promised future earnings look more valuable today, might be the key. 

Write to Paul J. Davies at paul.davies@wsj.com