Dongwu Strategy: The 1970s Stagflation Revelation - From Historical Review to Current Allocation Logic

Key Points of the Report

This report draws lessons from history by reviewing the causes of two stagflation episodes in the 1970s and the performance of major asset classes, providing ideas for asset allocation. It is important to emphasize that:

First, we are discussing the risk of overseas (especially U.S.) stagflation. The high fiscal deficit of the U.S. economy itself exerts upward pressure on inflation. Under the impact of rising oil prices, the risk of stagflation has increased. Meanwhile, China’s economy is in a bottoming-out and high-quality development stage, and its growth trajectory is difficult to change easily.

Second, we are not predicting that stagflation will necessarily recur, but highlighting the asymmetric risk-reward profile: If oil prices in a low-probability scenario rise to a $150–200 median, it would significantly impact overvalued, highly leveraged assets. Once this tail risk materializes, potential losses far outweigh potential gains. Based on this risk-reward asymmetry, the market is also inclined to shift structurally.

How did major stagflation in the 1970s and 1980s occur?

In summary, it was mainly caused by three factors:

1. Keynesian-led monetary and fiscal easing, which was the core internal cause of U.S. stagflation in the 1970s;
2. Middle Eastern geopolitical conflicts that tightened oil supply and caused oil prices to surge, triggering input-driven inflation and two rounds of stagflation;
3. The collapse of the Bretton Woods system and dollar devaluation, which exacerbated stagflation through institutional factors.

How did major asset classes perform during stagflation?

Equity markets: The U.S. stock market showed clear divergence. During the first stagflation (1973–1974), U.S. stocks plunged sharply; during the second (1979–1980), the market reversed its decline and rose.

Bond market: Bond yields surged significantly, entering a bear market. The transmission of stagflation to bond yields mainly occurred via two channels: high inflation pushing up nominal interest rates, and monetary policy impacts on rates.

Commodities: Overall performance was relatively good, with the weakening dollar being a key factor. During the two stagflation crises in the 1970s, crude oil and gold delivered excess returns. Industrial metals like copper and aluminum were more weakly correlated. Therefore, if we compare to the current environment, after the risk of overseas stagflation intensifies, market expectations of a hawkish Fed and a stronger dollar tend to pressure commodity prices, leading to declines in gold, copper, and other high-level prices.

What lessons do the performance of Japanese and US stock markets during past stagflation periods offer for China’s A-shares today?

The 1970s oil crises and global stagflation are unlikely to simply repeat in this cycle. However, the current macro environment in the U.S. has certain “stagflation risks”; China’s macro environment is quite different, with unique industrial advantages and a complete economic system, so the A-share market may not have a direct positive correlation with U.S. stagflation risks. Instead, rising overseas risks might highlight the advantages of domestic assets.

Therefore, when revisiting history to inform current A-share allocation logic, it should not be a “stick to the boat” approach, but rather a careful extraction of core experience that fits market scenarios, serving as a reference for sector and market judgment. If markets trade around the overseas stagflation logic, the performance of the Japanese stock market in the 1970s, especially the high-end manufacturing sector, provides some reference for A-shares; similarly, the performance of U.S. tech stocks during that period offers lessons for China’s tech sector.

Key insights:

1. Even if entering an overseas stagflation trading environment, with a complete manufacturing system and leading energy transition strategies, A-shares are expected to outperform Japan’s 1978 experience, demonstrating stronger resilience and becoming a “safe haven” for global funds.

2. Under overseas stagflation, the broad energy sector is likely to perform best.

3. Tech stocks may face overall adjustments, but strong industrial trends will persist through cycles. High-flying story stocks may adjust, but infrastructure companies with moats, pricing power, and solid earnings—such as storage, advanced process, and semiconductor equipment—are expected to outperform.

4. Historically, during overseas stagflation, consumer sectors tend to have weak anti-inflation properties and underperform the market, but China’s consumer sector may not be overly pessimistic due to stronger endogenous resilience, complete supply chains, and ongoing domestic recovery.

5. High-end manufacturing sectors benefiting from industrial advantages are expected to maintain relative resilience.

Risk warnings: economic recovery slower than expected; policy implementation weaker than expected; geopolitical risks; overseas policy uncertainties.

Main Body of the Report

Stagflation is a special macroeconomic imbalance characterized by high inflation and economic stagnation with high unemployment simultaneously. The U.S. experienced two typical stagflation crises in the 1970s, from 1973 to 1974 and from 1979 to 1980. During this period, U.S. inflation soared, with CPI YoY generally above 10%, and PPI YoY exceeding 20%. Meanwhile, GDP growth contracted significantly, and unemployment rose, leading to a comprehensive economic downturn. In fact, major economies like the UK, Germany, and Japan also experienced noticeable stagflation in the 1970s, with global economic growth stalling temporarily. Currently, ongoing conflicts in the Middle East have driven oil prices higher. The latest U.S. February PPI YoY was 3.4%, well above the forecast of 3.0%. Investors should note that this figure does not yet fully incorporate the impact of rising oil prices, implying that PPI growth could accelerate further.

In this context, stagflation expectations are rising further. This report uses history as a mirror, reviewing the causes of the two 1970s stagflation episodes and the performance of major assets to inform asset allocation. It is important to emphasize that:

First, we focus on the risk of overseas (especially U.S.) stagflation. The high fiscal deficit of the U.S. exerts upward pressure on inflation. Under the impact of rising oil prices, stagflation risk has increased. Meanwhile, China’s economy is in a recovery and high-quality development phase, with a growth trajectory that is hard to alter easily.

Second, we are not predicting that stagflation will necessarily recur, but highlighting the asymmetric risk-reward profile: If oil prices in a low-probability scenario rise to a median of $150–200, it would significantly impact overvalued, highly leveraged assets. Once this tail risk materializes, potential losses far exceed potential gains. Based on this risk-reward asymmetry, the market tends to shift structurally.

1. How did major stagflation in the 1970s and 1980s occur?

In summary, the two stagflation episodes in the 1970s were mainly caused by three factors:

1. Keynesian dominance, with monetary and fiscal easing leading to inflation.
2. Middle Eastern conflicts that restricted oil supply and caused price surges, directly triggering input-driven inflation.
3. The collapse of the Bretton Woods system and dollar devaluation, which worsened stagflation through institutional channels.

During stagflation, major asset classes showed distinct performance:

Equities: The U.S. stock market diverged sharply. During the first stagflation (1973–1974), stocks plunged; during the second (1979–1980), the market reversed and rose.

Valuation and earnings-driven analysis:
The first decline was mainly due to valuation compression (“killing the valuation”). In the early 1970s, U.S. stocks experienced a “Beautiful 50” rally, with core stocks at high valuations and signs of bubble. When stagflation hit, inflation spiraled out of control, and the economy plunged into recession, risk appetite plummeted, and overvalued sectors were hit first, dragging the overall market down until valuations normalized.

The second rally was driven by earnings improvement:
After valuation correction, the S&P 500’s valuation was low, with limited downside. As earnings expectations improved, the index rebounded. Fed Chairman Volcker’s aggressive tightening to combat inflation improved market expectations. Structural reforms and technological investments—such as rising consumer spending and growth in electronics and computing—also supported corporate profits.

Bond yields surged, entering a bear market. During both stagflation phases, 10-year Treasury yields rose sharply, especially in the second, exceeding 15%. The transmission channels included:

• High inflation pushing nominal rates higher.
• Fed’s rate hikes to curb inflation, raising real interest rates.
  In the second phase, yields rose even more due to aggressive rate hikes by Volcker, with the federal funds rate approaching 20%.

Commodities performed well, with a weaker dollar being a key factor. During the 1970s crises, crude oil and gold delivered excess returns. Oil benefited from supply constraints in the Middle East, while gold’s price was driven by its monetary attribute after the Bretton Woods system’s collapse. Industrial metals like copper and aluminum were more weakly correlated, as demand declined amid economic slowdown, offsetting the benefits of dollar weakness.

If we compare to today, the risk of overseas stagflation would likely lead to expectations of a hawkish Fed and a stronger dollar, pressuring commodity prices, causing gold and copper to retreat from high levels.

The 1970s oil crises and global stagflation are unlikely to be simply repeated in this cycle, but the current macro environment in the U.S. has certain “stagflation risks.” China’s macro environment is quite different, with unique industrial advantages and a complete economic system, so the A-share market may not be positively correlated with U.S. stagflation risks. Instead, rising overseas risks could highlight the advantages of domestic assets.

Therefore, when applying historical lessons to current A-share allocation, it should not be a “stick to the boat” approach, but a careful analysis to extract core experience suitable for scenario development, serving as a reference for market and sector judgment. If markets trade around the overseas stagflation logic, the Japanese stock market in the 1970s, especially high-end manufacturing, offers some reference for A-shares; similarly, U.S. tech stock performance then provides lessons for China’s tech sector.

Key insights:

• Even in an overseas stagflation environment, with a complete manufacturing system and leading energy transition strategies, A-shares are expected to outperform Japan’s 1978 experience, demonstrating stronger resilience and becoming a “safe haven” for global funds.

• Under such conditions, the broad energy sector is likely to perform best.

• Tech stocks may face overall adjustments, but strong industry trends will persist. Sector leaders with moats, pricing power, and solid earnings—such as storage, advanced process, and semiconductor equipment—are expected to outperform.

• Historically, during overseas stagflation, consumer sectors tend to have weak anti-inflation properties and underperform the market, but China’s consumer sector may not be overly pessimistic due to stronger endogenous resilience, complete supply chains, and ongoing domestic recovery.

• High-end manufacturing sectors benefiting from industrial advantages are expected to maintain relative resilience.

4. Summary

This report uses history as a mirror, reviewing the causes of two stagflation episodes in the 1970s and the performance of major assets, providing ideas for asset allocation. It is important to emphasize that:

First, we focus on the risk of overseas (especially U.S.) stagflation. The high fiscal deficit exerts upward pressure on inflation, and rising oil prices have increased stagflation risk. China’s economy is in an upward phase, with a growth trajectory that is hard to change easily.

Second, we are not predicting that stagflation will necessarily recur, but highlighting the asymmetric risk-reward profile: If oil prices in a low-probability scenario rise to $150–200, it would significantly impact overvalued, highly leveraged assets. Once this tail risk materializes, potential losses far outweigh potential gains. This risk-reward asymmetry makes the market prone to structural shifts.

In summary, the two major stagflation episodes in the 1970s were mainly caused by three factors:

1. Keynesian-led monetary and fiscal easing, which was the core internal cause;
2. Middle Eastern conflicts that restricted oil supply and caused price surges, directly triggering input-driven inflation;
3. The collapse of the Bretton Woods system and dollar devaluation, which worsened stagflation through institutional factors.

During stagflation, U.S. stocks showed clear divergence:
The first stagflation (1973–1974) saw sharp declines; the second (1979–1980) saw a reversal and gains.
From valuation and earnings perspectives, the first decline was mainly valuation compression (“killing the valuation”). The second rally was driven by earnings growth, supported by Fed tightening and structural reforms.

Bond yields surged, entering a bear market:
In both phases, 10-year Treasury yields rose sharply, especially in the second, exceeding 15%. The transmission channels included inflation expectations and Fed rate hikes, with aggressive tightening by Volcker pushing yields even higher.

Commodities performed well, with a weaker dollar being a key factor:
During the 1970s crises, crude oil and gold delivered excess returns. Oil benefited from supply constraints, and gold from monetary instability. Industrial metals like copper and aluminum were more weakly correlated, as demand slowed amid economic slowdown, offsetting dollar effects.

If we compare to today, the risk of overseas stagflation would likely lead to expectations of a hawkish Fed and a stronger dollar, pressuring commodity prices, causing gold and copper to retreat from high levels.

The 1970s oil crises and global stagflation are unlikely to be simply repeated in this cycle, but the current macro environment in the U.S. has certain “stagflation risks.” China’s macro environment is quite different, with unique industrial advantages and a complete economic system, so the A-share market may not be positively correlated with U.S. stagflation risks. Instead, rising overseas risks could highlight the advantages of domestic assets.

Therefore, applying historical lessons to current A-share allocation should not be a “stick to the boat” approach, but a careful analysis to extract core experience suitable for scenario development, serving as a reference for market and sector judgment. If markets trade around the overseas stagflation logic, the Japanese stock market in the 1970s, especially high-end manufacturing, offers some reference for A-shares; similarly, U.S. tech stock performance then provides lessons for China’s tech sector.

Key takeaways:

• Even in an overseas stagflation environment, with a complete manufacturing system and leading energy transition strategies, A-shares are expected to outperform Japan’s 1978 experience, demonstrating stronger resilience and becoming a “safe haven” for global funds.

• Under such conditions, the broad energy sector is likely to perform best.

• Tech stocks may face overall adjustments, but strong industry trends will persist. Sector leaders with moats, pricing power, and solid earnings—such as storage, advanced process, and semiconductor equipment—are expected to outperform.

• Historically, during overseas stagflation, consumer sectors tend to have weak anti-inflation properties and underperform the market, but China’s consumer sector may not be overly pessimistic due to stronger endogenous resilience, complete supply chains, and ongoing domestic recovery.

• High-end manufacturing sectors benefiting from industrial advantages are expected to maintain relative resilience.

5. Risk Warning

• Economic growth slower than expected: could impact corporate earnings recovery and increase market uncertainty.

• Policy implementation weaker than expected: may hinder economic recovery and lead to capital outflows, affecting stock performance.

• Geopolitical risks: extreme geopolitical events could suppress overall market risk appetite and increase volatility. If Middle East tensions worsen and oil prices spike uncontrollably, it could push U.S. bond yields higher, exerting systemic pressure on A-shares and global tech valuations.

• Overseas policy uncertainties: risks related to interest rate cuts and tariffs under the Biden administration.

(From Dongwu Securities)