Lessons from the 1970s and 1980s
The Federal Reserve is currently engaged in a battle to rein in inflation. It carries risks for the stock market. High interest rates can be bad for stock prices. As well, the fight may well bring on a recession that would hurt the economy and stock prices.
What I want to look at in this post is whether investors should be adjusting their asset allocation in face of these risks. Currently I’m 100% in stocks. Should we lighten up on stocks or even sell all of them and go to bonds?
The Great Inflation
To address this question I’m going to look at the experience of the late 1970s and through the mid-1980s. It has been dubbed ‘The Great Inflation’.
Since 1975 there have been three momentous economic/financial episodes: The Great Inflation, the Dot Com bubble and The Great Financial Crisis. They are instructive on how to deal with the future. Each brings its own lessons. How to deal with a true stock bubble (e.g. Dot Com) or how to deal with a true financial crisis (e.g. GFC) doesn’t necessarily help in figuring out how to deal with a fight against supercharged inflation.
Few investors today have ever experienced living in a period of extremely high inflation. And of course most investors today have not experienced what happens to the stock market/stock prices/stock values during a period when the Federal Reserve is using forceful monetary tools (e.g. high interest rates, quantitative tightening) to rein in epic inflation.
There have been many more crises in the last fifty years from the Savings and Loan crisis, the Asian contagion, Mexican sovereign default and Russian sovereign default. But these crises were all relatively contained and had limited impact on the overall stock market.
An inflation fighter
Paul Volcker was appointed chair of the Federal Reserve in the summer of 1979. Inflation was in runaway mode. Take a look at the chart below that comes from Ben S. Bernanke’s new book titled 21st Century Monetary Policy 2022 p.11. Inflation was headed into double digits.
Over the previous five years the Fed and the U.S. government had been fighting inflation but it just kept getting worse. The Nixon administration even brought in wage and price controls.
As Ben Bernanke, a former Fed chair, writes: “The conquest of inflation was a landmark accomplishment with enduring benefits, but it came with heavy costs. After a brief recession in 1980 and a short rebound, the economy slumped deeply in 1981 and 1982, with the unemployment rate peaking at a painful 10.8 percent in November and December 1982.” (Bernanke, 2022) p.37. So both inflation and unemployment were a problem. It took until 1987 to get the unemployment rate down to a reasonable 6%.
I recall investing in a real estate limited partnership in the late 1970s. I borrowed the money. By the early 1980s I was paying over 20% on the loan. This sort of thing sears itself in your mind.
As for the impact of inflation fighting on the stock market, let’s look at my total returns from our retirement savings from 1975 to 1985. They are set out in the table below. The number on the right is the total nominal return for each calendar year. So with inflation over 12% in 1980 the real return was not 25.4% but closer to 13%.
From 1975 to 1985 all our retirement savings were invested in an actively managed all-stock mutual fund. During that period I opened a small investment account through which I practiced investing on the side. It was only in 1985 that I took over managing all our savings myself. The other thing I would note is that the mutual fund was invested almost exclusively in Canadian stocks. I don’t think that changes our present discussion as the Canadian economy and the U.S. economy operate pretty much in lockstep. I think these return numbers from a mutual fund are not a bad proxy for what an investor in common stocks would have experienced during this period.
The main tool adopted by Paul Volcker in that period to fight inflation was monetary tightening, i.e. high interest rates. There were two recessions, one mild and the second deep, in 1981 and 1982. Our family’s life saving dipped by .7% in nominal terms in 1982 and more like 13% in real terms. The following year 1982, was a year of deep recession and our total nominal return was 18.1% but less in real terms.
My takeaway from this experience was and still is, that there is no need to change one’s asset allocation to either anticipate or react to high inflation, monetary tightening and potential recessions that are associated with serious inflation of the kind seen in the period of The Great Inflation.
At the annual Jackson Hole symposium recently, the chair of the Federal Reserve said he expected the Fed would raise rates throughout next year. Officials of the European Central Bank said the lessons of the 1970s show there should be no easing of interest rates at the first signs of a dip in inflation. Central bankers made it clear that, if necessary, tightening of monetary conditions would take place even if they were expected to lead to a recession.
Specifically, the Fed chair Jay Powell said that to combat inflation, “it is likely to require a sustained period of below-trend growth” and that in prior bouts of high inflation, “a lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation.’’
A changing world and types of inflation
The economy today is vastly different from that in the 1970s and 1980s. We have moved from an economy driven by manufacturing to one driven more by services. The economy is more globalized. The U.S. is less dominant. Companies today invest less in physical assets and more in intangibles. Labour markets have changed.
The last twenty years have demonstrated that deflation is a worse threat to the economy than is inflation. To address deflation central banks have had to create new tools like quantitative easing. Inflation can much more easily be brought under control than can deflation. Traditional tools like monetary tightening and forward guidance can, for the most part, always grind even the most persistent inflation down, although at some cost.
I say ‘for the most part’. Some inflation shocks such as oil and natural gas prices today and in the 1970s are external. Tight monetary policy in Europe will not tame natural gas prices. Tight monetary policy in the U.S. will not tame supply chains disruptions.
My experience as an investor in the 1970s and 1980s suggests that there is nothing to gain and much to lose in trying to carry out some kind of dynamic asset allocation to see through this period when the Fed is on a mission to tame high inflation. That would be market timing. The superb companies that we hold stocks in should actually be quite good at coping with inflation and Fed efforts to tame it.
To read more about asset allocation strategies take a look at my post:
Other posts touching on asset allocation are:
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