Are we heading back to the 1970s?

Stock markets may be up, but that doesn't mean it's business as usual. Inflation is getting out of hand and policymakers don't seem to have learnt from past events, which is bad news for stocks.

As far as stocks are concerned, all is well with the world. American, British and European indices have risen to four-month highs. The message seems to be that the credit-crunch-induced slowdown will be "short and not especially sharp, but enough to knock all these silly inflation stories on the head and we can look forward to a resumption of business as usual", says Jim Wood-Smith of Williams de Broe.

But business as usual is about the last thing we're likely to get. For starters, expect plenty more stories about rising prices. Following April's sharp jump in UK inflation, the market's inflation expectations measured by the gap between the yields on index-linked and conventional gilts have jumped to a ten-year high.

Bond markets now expect retail price inflation to average 3.8% over the next 20 years. The jump may be "the first sign that the markets are starting to lose faith" in policymakers' ability to deliver "low and stable" inflation, says Capital Economics. The public's expectations are also heading upwards, fuelling fears of a wage-price spiral.

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No wonder. Inflation is "accelerating and broadening", says Tim Bond of Barclays Capital. It has spread into UK goods and services, while import prices from outside the EU, excluding oil, are rising at a 5% annual pace. In the eurozone, despite the strong currency, non-fuel, non-food import prices are climbing by 6.5% year-on-year.

Now that emerging market workers are "battling for their income share", as John Plender puts it in the FT Chinese wage inflation in the third quarter of 2007 was up 22% year-on-year "the developed world will have to pay more for its imports". The developing world is now spurring inflation of both commodities and import prices. With imported competitive downward pressure on prices now ending, firms hope to put prices up; the April survey of small businesses in America showed a sharp rise in those intending to do so, even though demand is weak.

Such readings have not been seen since 1981, says Bond. Consumers are expecting higher inflation, with a net 30% of European workers anticipating accelerating inflation over the next year. Central banks have done little about this; global real interest rates have drifted lower as inflation has risen. Inflation conditions are reminiscent of the start of the 1970s and the global policy reaction is similar, so the inflation outcome over the next few years is likely to resemble the 1970s. That was nasty for stocks: between 1969 and 1979 the average annualised real return from equities was 2.3% in Britain and 0.9% in America, says Barclays Capital.

There is pressure on valuations when inflation is high as economic growth becomes more volatile and inflation threatens the value of future profits. In the 1970s, only oil and gas, financials and industrial goods enjoyed positive real earnings growth. Similarly, the only sectors likely to deliver positive real returns in this inflationary period are energy, basic resources and industrial goods and services those related to raw materials, says BarCap.

Last week's inflation figures in Britain highlight the potential overall squeeze on earnings, says The Economist. Firms pushed output prices up to 7.5%, but this wasn't nearly enough to compensate them for a 23% jump in the cost of raw materials. And "it will be even more difficult to maintain profit margins when consumers are under pressure".

And as we noted last week, the credit crisis looks far from over and is only just beginning to affect America and European economies. Emerging economies are not only unlikely to decouple from lower Western demand, but are having to tighten monetary policy to keep a lid on inflation, thus hampering growth. That also portends a slide in commodities. A likely sharp global slowdown means deflation looks more of a problem than inflation, reckons Dresdner Kleinwort. But whatever happens, it's hardly going to be much fun for equity investors.