Nothing could seem more incongruous in today’s economic environment which is characterised by persistent low inflation, low unemployment, negligible wage growth and near-zero interest rate, than the prospect of stagflation – being rising inflation that coincides with falling economic growth rates.

However, many of the causes of the 1970’s stagflation phenomenon can be seen today, and whilst a return to double-digit interest rates isn’t going to happen, we could see a period of rising inflation and falling GDP growth that would be just as painful.

In this instalment of our five-part investment strategy guide preview we outline why we think the biggest risk to equities markets is a surprise breakout of inflation in the United States.

For the past 20-years inflation in the cost of goods has hovered around 0% per annum as improved manufacturing processes and outsourcing of production to lower labour cost countries has reduced production costs. Throughout this same period, the cost of services has increased between 2-4% per annum, falling when unemployment rises and vice versa – a traditional Phillips curve relationship (Figure 1).

Since the GFC, the traditional Phillips curve for goods (Figure 2) has inverted, with goods inflation falling even as unemployment falls and wages rise. One explanation for this breakdown is that the outsourcing of production to emerging countries has substituted the importance of US labour costs for the cost of labour in China, Vietnam, et al. where a large portion of goods are manufactured. Thus, even as domestic wages rise, the product cost of goods can remain stable or fall.

In contrast, an inversion in the Philips curve is not evident for services (Figure 3), as they are provided by domestic workers and hence the cost to provide the service are driven by domestic employment market dynamics.

This data explains why monetary policy has been less effectual over the last decade and illustrates that inflation has not disappeared forever but has been hidden by the benefits of globalisation, a process that may be ending as geopolitical tensions rise.

The original 1970's stagflation was triggered by a combination of easy monetary policy, import cost inflation due to tariffs, currency falls and an oil shock. Today we have had a world awash in cheap money for the past decade and we see four factors that could lead to a surprise breakout in inflation, whilst economic growth remains tepid.

• Services represent an increasing portion of the CPI basket, having increased from 50% in the 1970s to 70% today. The higher the proportion of services, the higher the inflation figures.

• Trade tariffs increase the costs of imports, or cause substitution to more expensive production, resulting in higher inflation without economic benefit.

• Globalisation peaks, halting the downwards pressure on production costs.

• Labour costs are rising in the developed world, reducing the incentive to relocate production and diminishing production cost savings from labour.

Should inflation increase due to a combination of the factors above, the resolve of central banks around the world would be severely tested. A tightening cycle with rising unemployment would be likely and a de-rating of equities markets by 20-30% a certainty.

Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.

For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.