(Repeat to increase readership. Opinions expressed here are those of the author, a columnist for Businesshala.)
ORLANDO, Fla., Oct 13 (Businesshala) – With prices rising and economic growth slowing, many investors are looking past where US markets may be headed. While “inflation” of the 1970s brings back memories, investors may want to revisit the mid-2000s instead.
Energy prices, inflation expectations and bond yields rose in both periods, with anemic growth and central banks moving towards tighter monetary policy. However, the mid-2000s were much milder.
While all economic and market cycles are unique – nothing more than the slump, rebound and inflation of the past 18 COVID months due to supply constraints and shortages – the conditions that exist today are similar to those that occurred in 2005.
As in 2005, US equity valuations are now slowly falling. The S&P 12-month forward price/earnings ratio is now around 20.5, down from 23 a year ago, reflecting a decline from 16 to 14 during 2005.
This downward trend continued into 2006. Given that the P/E ratio is still historically high, there’s every reason to expect this trend to pick up next year, and potentially accelerate if guidance from third-quarter earnings is disappointing.
The S&P 500 saw two minor corrections in 2005, first by 8% in March–April and then by 6% in September–October. The index was down 5% for the first time in nearly a year and a 5% to 10% correction is in the cards by the end of the year, according to nearly two-thirds of more than 600 market professionals recently surveyed by Deutsche Bank. .
Some analysts have begun to point to the mid-2000s as a possible case study. Morgan Stanley’s Andrew Sheets wrote in a note Sunday that 2005 was “an interesting, recent example of a stagflation scare following a mid-cycle transition.”
Calm or decency?
In some key respects, the inflation picture is more similar to the 2005s than the 1970s.
Headline annual inflation is now just above 5%, the highest in 13 years, compared to a peak of less than 5%, which was a 14-year high at the time. There is no sign of double-digit print since the mid- and late ’70s, a period of a serious wage-price spiral.
The inflation of the 1970s is precisely linked to energy shocks and shortages. But oil and natural gas prices rose significantly in the mid-2000s and consumers were the major driver behind the widespread increase in prices. Just like today.
Brent crude more than doubled to $65 a barrel by the end of 2005, from about $30 in early 2004. It has more than doubled to $83 a barrel in the past 18 months, and will test $100 as the majority view. Deutsche Bank survey of investors.
US natural gas futures recently rose to a 12-year high of $5.565 per million British thermal unit after a nearly 40% spike in just six weeks. In July–August 2005, natgas prices rose almost 50% to a still record high, just under $14/mmBtu.
There is no doubt that investors and policy makers should remain cautious as inflation expectations are measured by the crossing of the curve towards May’s multi-year peak. For the US 5-year rate, it is 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 been trading mostly below 20 since March, suggesting that equity markets are broadly comfortable with higher future levels of inflation, interest rates and bond yields.
As Morgan Stanley’s Sheets points out, inflationary markets mean that price pressures will ease rather than spiral over time. In addition, nominal interest rates are low, and equity valuations are close to all-time highs.
Contrary to what was true, in the 1970s.
“If ‘inflation’ means the ‘1970s,’ a time of wage-price spirals and high unemployment, it is clearly not it,” he said.