A trader works on the trading floor at the New York Stock Exchange (NYSE) in Manhattan, New York City, U.S., May 18, 2022. REUTERS/Andrew Kelly

LONDON, June 23 (Reuters Breakingviews) - Economists may disagree about the causes of inflation. Still, investors have plenty of historical experience to draw upon. From their perspective, rising prices lead to the large-scale destruction of paper wealth. Bondholders are in danger of being wiped out. Even the owners of real assets, such as stocks and property, can suffer heavy losses. Finding a permanent shelter from the inflation storm is no simple task.

In the aftermath of the global financial crisis of 2008, I spent several months with a colleague, Chris Wu, examining investors’ experience of the 1970s. At the time, we thought conditions were ripe for another inflation episode. As in that earlier decade, real interest rates had turned negative, governments were running large fiscal deficits, and international monetary reserves had been growing rapidly. Our timing turned out to be poor. Deflationary forces were more entrenched than we anticipated.

Now that inflation is at a four-decade high on both sides of the Atlantic, however, it is time to revisit that discarded project. What we found, unsurprisingly, is that long-dated bonds were the worst performing asset class, losing value both from the drop in the purchasing power of money and the rise in interest rates. Between 1977 and 1982, 10-year U.S. Treasury bonds declined by 44% in real terms. The bond risk premium climbed as investors demanded yields above the trailing inflation rate. Credit spreads rose in line with inflation.

Equities, which represent claims on real assets, should not suffer a permanent loss of capital during inflationary periods. In the 1970s, however, the valuation of U.S. stocks collapsed as earnings yields rose in tandem with long-term interest rates. The price-to-earnings ratio for the U.S. stock market (based on 10-year average profits) fell from 24 times in 1966 to below 7 times in 1982. U.S. real estate companies fared poorly as rents failed to keep up with inflation and property investors demanded higher rates of return.

It wasn’t all bad news. While the S&P Composite 1500 Index of U.S. stocks lost 44% in real terms over the course of the 1970s, shares that were cheap relative to fundamentals delivered positive real returns. There are several reasons why these so-called value stocks had such a triumphant decade. First, they started out inexpensive relative to the rest of the market. Second, their reasonable valuations were a sign that investors had low expectations, giving value stocks a built-in margin of safety during that turbulent decade. Third, high earnings yields rendered them less sensitive to rising interest rates.

Commodities, a major component of the consumer price index, provided even better protection. The price of oil and gold rose more than fivefold over the decade. The share prices of miners, energy companies and coal producers delivered great returns. Investors who sat on cash also did surprisingly well. By avoiding losses when markets declined, cash provided investors with the opportunity to acquire cheap assets at the trough. Those who kept their dry power in the currencies of the least inflation-prone countries, such as Switzerland and Germany, did especially well.

So far this year, financial markets have followed the playbook of the 1970s. Once again, central bankers have been slow to respond to the return of inflation. As in that earlier decade, rising prices have turned out to be a global phenomenon. Bond prices have declined as the yield on U.S. 10-year Treasury bonds has almost doubled. The performance of the stock market confirms that valuations are liable to fall as inflation picks up. Value stocks have outperformed yet again. The oil price has soared, and commodity stocks are demonstrating their inflation-fighting credentials. Investors who sat on cash at the start of the year are content; currency speculators who bought Swiss francs are even happier.

So what’s the catch? As the inflation chart from the late 1960s onwards shows, inflation is a cyclical phenomenon. During that era there were three separate periods of rising consumer prices in the United States: from 1968 to 1970, 1973 to 1975, and 1978 to 1980. Each cycle started with an inflation surprise that prompted central banks to tighten monetary policy. Rising interest rates then drove the economy into recession. After each inflationary peak, policymakers relaxed their guard, whereupon prices flared up again. Over the course of each cycle, the rate of inflation peaked at successively higher levels.

Investors, whose inflation expectations tend to be backward-looking, were blindsided by what became known as the “stop-go” cycle. Past winners turned out to be tomorrow’s losers. Commodities proved particularly volatile, forming bubbles at one moment and crashing the next. In the stock market downturn of 1973 to 1975, commodity stocks turned out to be more correlated with other shares than with the price of the underlying materials. After inflation peaked, safe-haven currencies lost their appeal and declined.

The current outbreak of inflation could prove to be even more cyclical than its predecessor. Central banks have printed more money and kept interest rates lower than five decades ago. There is no apparent end to the energy crisis. On the other hand, the assumption that interest rates would remain “lower for longer” is embedded deep in the financial architecture, rendering the system acutely vulnerable to even a slight monetary tightening. With the global economy tottering under a mountain of debt, deflation remains a lingering threat.

The traditional “buy-and-hold” approach to investment makes little sense in this environment. In the first half of the 1970s, the benchmark portfolio held by many American investors - 60% in equities and 40% in bonds - lost more than half of its value in real terms. Today, U.S. stocks trade at much higher valuations and bond yields are much lower. To survive the turbulent times ahead, investors must learn to ride the inflation cycle.

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

Edward Chancellor’s “The Price of Time: The Real Story of Interest” will be published by Penguin on July 7.

Our Standards: The Thomson Reuters Trust Principles.

The Federal Reserve may be underestimating the price to pay for taming inflation. The U.S. central bank projects the trade-off for lowering the rate of rising prices is unemployment increasing to 4.1% in 2024. Yet it reckons the economy will still grow.

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