Stagflation Will Be Back

The Real Estate Espresso Podcast

Stagflation Will Be Back

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Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. On today’s show, we’re talking about a parallel between present day circumstances and what happened in 1973.

Now this is not a political show. I’ve not commented on the events in the Middle East, and I’m not going to make this about the Middle East. Now, the mid-1970s were characterized by the simultaneous surge in inflation and economic contraction. Those were economic events that, up until that point, were considered to be mutually exclusive.

The trigger, in October of 1973, was the Arab oil embargo against Western countries as a result of Western support for Israel during the Yom Kippur War. At that time, all of the neighboring countries surrounding Israel launched a surprise attack on Israel from all sides in the middle of the highest holiday in Judaism.

Oil prices quadrupled almost overnight, jumping from roughly $3 a barrel to nearly $12 a barrel. Since oil was and is the lifeblood of transportation and manufacturing, the cost of nearly every good and service rose almost simultaneously.

Before the 1970s, most economists believed in the Phillips Curve, which suggests that inflation and unemployment have an inverse relationship. If inflation goes up, then unemployment goes down, and vice versa. Stagflation broke that rule. It’s characterized by a simultaneous economic contraction, high unemployment, and rapidly rising prices.

The oil embargo acted as an economic shock to the system. It squeezed the economy from both sides. Higher energy costs acted like a tax on consumers and businesses. Factories became more expensive to operate, leading to cutbacks in production. Businesses struggled with rising costs and falling demand, and unemployment began to climb.

Because oil is an input for everything from gasoline to plastics to fertilizers, the price hike was baked into the cost of living. As prices rose, workers demanded higher wages to keep up. Employers raised prices again to cover higher wages, creating a self-reinforcing loop of inflation, the so-called wage-price spiral. We’re starting to see the beginnings of that again, with governments, for example, in New York City now talking about raising the minimum wage to $30 an hour.

Now, the embargo didn’t cause a temporary blip. It changed the structural behavior of the U.S. economy. Even after the embargo ended in 1974, inflation expectations remained anchored. They were high. It eventually took several years later for Paul Volcker, as the head of the Federal Reserve, to raise interest rates to such a level, peaking at over 20%, to finally break the back of inflation.

So the Arab oil embargo was the match that lit the fire. It proved that a sudden shortage of a critical resource could simultaneously destroy economic growth and send prices through the roof.

So today, we have a partial constriction of oil flowing through the Strait of Hormuz. About 2.2 million barrels per day is still flowing through the Strait, which is a sharp reduction from the approximately 20 million barrels a day that’s more typical. This is another oil supply shock, just like 1973. So oil price forecasts of $250 a barrel would, in fact, be in line with that four-times multiple in oil price that the Western economies witnessed in 1973.

The world financial markets are trying to make sense of what’s happening and infer the impact on investments. And there has been an enormous volatility in oil prices, as every statement from any world leader seems to influence oil prices.

In a recent interview, an oil analyst who I follow, Dr. Anas Alhaji, laid out a very different picture from the one that most people have been hearing. His central argument is that the crisis has not been primarily about Iran physically shutting down the Strait of Hormuz. In fact, he argues that such a move would make very little strategic sense for Iran. It would hurt its own interests and damage the neighboring countries far more than it would damage its principal adversaries.

Israel does not depend on energy imports from that route; the U.S. doesn’t either. So the idea that Iran would simply slam the doors shut and somehow gain strategic advantage is a little bit simplistic.

The reports of mining the Strait are also inaccurate; that makes no sense. Yes, there were 16 boats destroyed, but those boats were not actually in mining operations. They were docked or at anchor, at least according to a report I heard from the BBC. The U.S. media, on the other hand, is implying that they were actively mining the Strait of Hormuz. That’s incorrect.

Think about it: Iran has close to 60 desalination plants. This is where they remove the salt from seawater in order to produce drinking water. Imagine blowing up a large tanker with a million barrels of oil and you end up poisoning the drinking water for the entire nation. That wouldn’t make sense.

The mainstream media often prefers the simple story: good guys, bad guys, closure, escalation, retaliation. But these complex systems don’t work that way. In real assets, second-order effects are often more important than the headline event.

Now, if no tanker stops moving because they can’t get insured, then the practical result can resemble a blockade, even if one hasn’t formally closed anything. If production gets curtailed, it can take months to restore that output. That means a long tail of disruption that may matter more than the trigger event itself.

So there will be economic winners and losers as a result of this military action. President Trump doesn’t seem to be overly worried about high oil prices, and yet that is in stark contrast to virtually every speech he’s made over the years, including when he was a young man well outside of politics. He consistently has spoken about the need for low oil prices. While it’s hard to recognize his lack of focus on oil prices at the moment, it can only mean one thing: that he expects this action to be short-lived and for oil markets to normalize quickly.

Now, this time the U.S. is not reliant on oil from the Persian Gulf. But it’s not just oil that flows through the Persian Gulf; fertilizer does as well. A big percentage of the world’s fertilizer goes through the Strait of Hormuz.

If the oil supply remains constricted for more than a few weeks, I predict that stagflation will be upon us again. It’s a remake of the same movie with different actors.

As you think about that, have an awesome rest of your day. Go make some great things happen. I’ll talk to you again tomorrow.

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