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

Key Points of the Report

This report uses history as a guide, reviewing the causes of two stagflation episodes in the 1970s and the performance of major asset classes to inform asset allocation strategies. 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 exerts upward pressure on inflation, and the surge in oil prices has increased stagflation risk. Meanwhile, China’s economy is in a bottoming and high-quality development phase, making its growth trajectory difficult to alter easily.

Second, we are not predicting that stagflation will necessarily recur, but highlighting the asymmetric risk-reward profile: If oil prices unexpectedly rise to a $150–200 midpoint, it could significantly impact overvalued, highly leveraged assets. Once such tail risks materialize, potential losses could far outweigh potential gains. Based on this risk-reward asymmetry, markets may tend to shift structurally.

How did major assets perform during the stagflation of the 1970s and early 1980s?

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

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

Commodities: Overall performance was strong, with the weakening dollar being a key factor. During the two stagflation crises, oil and gold delivered excess returns. Industrial metals like copper and aluminum were relatively weak. Therefore, if we compare to the current environment, heightened overseas stagflation risk could lead to expectations of a hawkish Fed and a stronger dollar, which would pressure commodity prices, causing gold, copper, and others to retreat from high levels.

What lessons do the performance of Japanese and U.S. markets during stagflation in the 70s and 80s offer for China’s A-shares today?

The 1970s oil crises and global stagflation are unlikely to simply repeat in this cycle, but the current macro environment in the U.S. has certain “stagflation risks.” The U.S. is in the late stage of a monetary easing cycle, with high absolute interest rates; persistent high fiscal deficits exert rigid upward pressure on inflation, and ongoing geopolitical conflicts continue to disturb inflation expectations, increasing the probability of stagflation.

In contrast, China’s macro environment is fundamentally different: the economy is generally stable and improving, with external shocks less likely to cause substantial drag. However, due to trade linkages, global expectations can influence asset prices. With China’s unique industrial base and complete economic system, the performance of A-shares may not be positively correlated with U.S. stagflation risks; instead, rising overseas risks could highlight the advantages of domestic assets.

Therefore, when translating historical insights into current A-share allocation logic, it is essential to avoid rigid, dogmatic approaches. Instead, one should carefully analyze and extract core experience relevant to current market conditions, serving as a reference for sector and market judgment. If markets trade around overseas stagflation logic, the performance of the Japanese stock market in the 1970s, especially in high-end manufacturing sectors, offers valuable reference for A-shares, particularly for the high-end manufacturing sector. Similarly, the performance of U.S. tech stocks during that period can inform the outlook for A-shares’ tech sector.

Key Insights:

1. Even if the overseas stagflation scenario unfolds, China’s complete manufacturing system and leading energy transition strategies could enable A-shares to outperform Japan’s 1978 experience, demonstrating stronger resilience and becoming a “safe haven” for global capital.

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

3. Technology stocks may face overall adjustments, but strong industry trends will persist through cycles. High-flying thematic stocks may correct, 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 be less inflation-resistant and often underperform the broader market. However, A-shares’ consumer sector may not be overly pessimistic, given China’s stronger internal resilience.

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

Risk Warnings:

• Economic recovery slower than expected;
• Policy implementation weaker than anticipated;
• Geopolitical risks;
• Uncertainty in overseas policies.

Main Body of the Report

Stagflation is a special macroeconomic imbalance characterized by high inflation alongside stagnation and high unemployment. The U.S. experienced two typical stagflation crises in the 1970s: the first from 1973 to 1974, and the second from 1979 to 1980. During this period, U.S. inflation soared, with CPI YoY consistently above 10%, and PPI YoY exceeding 20%. Meanwhile, GDP growth contracted significantly, and unemployment rose in tandem, plunging the economy into a broad downturn. In fact, major economies like the UK, Germany, and Japan also experienced notable stagflation in the 1970s, leading to a period of global economic stagnation. Today, ongoing conflicts in the Middle East have driven oil prices higher, with recent U.S. February PPI YoY at 3.4%, well above the forecast of 3.0%. Investors should note that this data does not yet fully incorporate the impact of rising oil prices, implying that PPI growth could accelerate further.

In this context, stagflation expectations are intensifying. This report uses history as a reference, 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 in the U.S. exerts upward pressure on inflation, and rising oil prices have increased stagflation risk. Meanwhile, China’s economy is in a bottoming and high-quality development phase, making its growth trajectory difficult to change easily.

Second, we are not predicting that stagflation will necessarily recur, but highlighting the asymmetric risk-reward profile: If oil prices unexpectedly rise to a $150–200 midpoint, it could significantly impact overvalued, highly leveraged assets. Once such tail risks materialize, potential losses could far outweigh potential gains. Based on this risk-reward asymmetry, markets may tend to shift structurally.

1. How did major assets perform during the 1970s and early 1980s stagflation?

During the two stagflation cycles of the 1970s, U.S. stocks showed clear divergence. In the first (1973–1974), stocks declined sharply; in the second (1979–1980), the market reversed and rose.

From valuation and earnings perspectives, the first decline was mainly driven by valuation compression—market “killing the valuation.” In the early 1970s, U.S. stocks experienced a “Beautiful 50” rally, with core stocks at historically high valuations and signs of bubble formation. When stagflation hit, inflation spiraled out of control, and the economy plunged into recession, risk appetite plummeted, leading to a sharp sell-off in overvalued sectors. Only after the market bottomed did valuations return to reasonable levels.

In the second cycle, stock prices recovered mainly due to earnings growth. After the valuation correction, the S&P 500’s valuation was low, with limited downside. Driven by improved earnings expectations, the market oscillated upward. At that time, Fed Chairman Volcker implemented aggressive monetary tightening to combat inflation, improving economic outlooks. Meanwhile, structural reforms in the U.S. economy—such as rising consumer spending share and rapid growth in tech-related investments—supported corporate profits.

2. Bond yields surged, entering a bear market.** During both stagflation phases, the 10-year U.S. Treasury yield rose sharply, especially in the second cycle, when it exceeded 15%. The transmission channels included: high inflation pushing nominal rates higher, and monetary policy tightening raising real interest rates. Notably, in the second cycle, the yield increase was more pronounced due to Volcker’s aggressive rate hikes, with the federal funds rate reaching nearly 20%, which then transmitted to long-term yields.

Commodities performed well, with a weaker dollar being a key factor. In the 1970s, oil and gold delivered excess returns. Oil benefited from supply shocks—Middle East tensions limited supply and pushed prices higher, directly fueling inflation. Gold, as a monetary asset, was driven by the collapse of the Bretton Woods system and central banks’ gold purchases, boosting prices. Industrial metals like copper and aluminum were relatively weak; despite commodities’ financial attributes benefiting from a weaker dollar, the economic slowdown during stagflation suppressed demand and prices. Therefore, if we compare to today, heightened overseas stagflation expectations could lead to a hawkish Fed and a stronger dollar, pressuring commodity prices, with gold and copper retreating from highs.

3. What are the implications for China’s A-shares?

3.1. “Using history as a mirror,” but not rigidly copying

We believe that the 1970s oil crises and global stagflation are unlikely to be simply replicated in this cycle. However, the current macro environment in the U.S. has certain “stagflation risks.” The U.S. is in the late stage of monetary easing, with high real interest rates; persistent fiscal deficits exert rigid upward inflation pressures; and ongoing geopolitical conflicts continue to disturb inflation expectations, increasing the likelihood of stagflation.

In contrast, China’s macro environment is fundamentally different: the economy remains stable and improving, external shocks are less likely to cause substantial drag. However, due to trade linkages, global expectations can influence asset prices. With China’s unique industrial base and comprehensive economic system, the performance of A-shares may not be positively correlated with U.S. stagflation risks; instead, rising overseas risks could highlight the advantages of domestic assets.

Therefore, translating historical insights into current A-share strategies requires careful analysis rather than dogmatic approaches. Extracting core lessons relevant to current market conditions can serve as a reference for sector and market judgment. If markets trade around overseas stagflation logic, the Japanese stock market in the 1970s, especially in high-end manufacturing, offers valuable reference for A-shares, particularly for the high-end manufacturing sector. Similarly, the performance of U.S. tech stocks during that period can inform the outlook for A-shares’ tech sector.

3.2. What lessons do the 1970s and 1980s Japanese and U.S. markets offer for China today?

The 1970s oil crises and global stagflation are unlikely to be simply repeated, but the macro environment then and now share similarities—especially in the transition from depression to recovery in the Kondratiev cycle, with hardware leading. The infrastructure of AI, servers, optical modules, and storage has already begun to advance. If overseas stagflation persists, a stronger dollar could tighten global liquidity, potentially suppressing valuations of global tech stocks. Given current market valuations, it is advisable for A-shares to “distinguish the true from the false” and focus on high-quality core assets. We remain optimistic about storage, advanced process, and semiconductor equipment/materials sectors, as geopolitical tensions further tighten supply and demand for core tech products, reinforcing the growth prospects of these hard-tech assets.

4. What are the implications for China’s consumer sector?

Historically, during overseas stagflation, Japanese and U.S. consumer sectors generally underperformed and showed weak inflation resistance, with many sectors lagging the broader market. For example, in Japan, excluding globally competitive segments like appliances, domestic services, food, and textiles underperformed during stagflation, with cumulative gains/losses of -18%, -10%, and -1% respectively in 1979–1980. In the U.S., from 1970 to 1981, the consumer discretionary sector’s weight shrank from 20% to below 10%, while staples also declined. However, segments like agriculture and food retail, driven by geopolitical conflicts and rising input costs, showed resilience, with positive returns during that period. Conversely, leisure and travel sectors declined significantly.

For China, if the overseas stagflation framework applies, the consumer sector may not generate significant excess returns. But compared to Japan and the U.S., China’s internal resilience is stronger, with advantages in energy supply chains and ongoing domestic demand recovery. Therefore, the downside risk for Chinese consumer stocks may be more contained, and overall performance could outperform overseas markets.

5. Which high-end manufacturing sectors are likely to remain resilient?

China’s complete industrial chain and structural advantages position it to benefit from the global shift of capacity inward. During Japan’s second stagflation, high-end manufacturing sectors like machinery, precision instruments, electrical equipment, and transportation equipment posted positive returns, even if not as high as energy sectors. The current experience confirms China’s strong export substitution capacity: during the pandemic, leveraging a stable supply chain, China rapidly filled supply gaps, with export share rising from 13% in April 2020 to 16% in March 2021, a record high. With geopolitical conflicts increasing supply chain uncertainties, this trend could continue, favoring domestic high-end manufacturing.

Long-term, China’s manufacturing industry has a more advanced and complete system than Japan’s during its transition period. In 2024, manufacturing value added accounts for nearly 30% of global total, maintaining the top position for 15 consecutive years. China also leads in the complete industrial chain and has a significant advantage in new energy sectors. Amid supply chain restructuring driven by geopolitical tensions, high-end manufacturing capacity is expected to accelerate domestic transfer.

6. Summary

In conclusion, this report uses history as a mirror, reviewing the causes of two stagflation episodes in the 1970s and the performance of major assets to inform current asset allocation. It is important to emphasize that:

First, we focus on the risk of overseas (especially U.S.) stagflation. The high fiscal deficit and rising oil prices have increased this risk. Meanwhile, China’s economy is in an upward phase, with its growth trajectory difficult to alter easily.

Second, we do not predict that stagflation will necessarily recur, but highlight the asymmetric risk-reward profile: If oil prices unexpectedly rise to a $150–200 midpoint, it could significantly impact overvalued, highly leveraged assets. Once such tail risks materialize, potential losses could far outweigh potential gains. Markets may tend to shift structurally in response.

Overall, the main causes of the 1970s and early 1980s stagflation were:

1. Keynesian-driven monetary and fiscal easing, which triggered U.S. stagflation;
2. Middle East geopolitical conflicts constraining oil supply, causing input-driven inflation;
3. The collapse of the Bretton Woods system and dollar devaluation, which exacerbated stagflation.

During stagflation, U.S. stocks showed clear divergence: the first cycle saw sharp declines, driven by valuation compression (“killing valuations”), while the second cycle saw a recovery driven by earnings growth. Bond yields surged, entering a bear market: the 10-year Treasury yield rose sharply, especially in the second cycle, exceeding 15%. The transmission channels included inflation-driven nominal rate increases and monetary policy tightening, with the Fed raising rates aggressively under Volcker, pushing yields near 20%.

Commodities performed well, with a weaker dollar being a key factor. Oil and gold delivered excess returns during the crises, driven by supply shocks and monetary factors. Industrial metals like copper and aluminum were relatively weak, as demand slowed amid economic slowdown. If we compare to today, heightened overseas stagflation expectations could lead to a hawkish Fed and a stronger dollar, pressuring commodity prices, with gold and copper retreating from highs.

The 1970s oil crises and global stagflation are unlikely to be simply repeated in this cycle, but the U.S. macro environment still bears certain “stagflation risks.” China’s macro environment is different: with a complete industrial system and structural advantages, A-shares may not be positively correlated with global stagflation risks. Instead, rising overseas risks could highlight the advantages of domestic assets. Analyzing history helps us develop flexible, experience-based strategies rather than dogmatic ones. If markets trade around overseas stagflation logic, the Japanese stock market in the 1970s and the performance of high-end manufacturing sectors provide valuable references for A-shares. Similarly, the performance of U.S. tech stocks during that period can inform the outlook for China’s tech sector.

Key insights:

• Even amid overseas stagflation, China’s complete manufacturing system and energy transition strategies could enable A-shares to outperform Japan’s 1978 experience, demonstrating stronger resilience and becoming a “safe haven.”
• The broad energy sector is likely to perform best under overseas stagflation.
• Tech stocks may face adjustments, but core industry trends will persist; infrastructure companies 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 underperformed and showed weak inflation resistance, but China’s internal resilience and demand recovery could lead to relatively better performance.
• High-end manufacturing sectors benefiting from structural advantages are expected to maintain relative resilience.

7. Risks

• Economic growth slower than expected;
• Policy implementation weaker than anticipated;
• Geopolitical risks;
• Uncertainty in overseas policies.

(Article source: Dongwu Securities)