Long-run inflation swings have been powerful drivers of financial asset performance throughout economic history. These swings in long-run inflation result in inflation eras that can last multiple decades. We believe that a new inflation era is underway that will impact the performance of financial markets for many years to come.
The Inflation Era (1960s – 1980s)
Throughout economic history, periods of deflation were as prevalent as periods of inflation. Pre-WWII, there was no fiat money or automatic stabilisers, such as welfare grants, and little in the way of counter-cyclical fiscal policies. This left economies vulnerable to regular depressions that served to wash out financial and economic excesses and any inflationary pressures. Price spikes typically occurred only during wartime. However, the picture began to change in the second half of the 1960s, as depicted by the US GDP deflator, which measures the changes in prices for all the goods and services produced in an economy – see Figure 1.
Figure 1 – Inflation is a “modern” issue
The 1960s saw the beginning of a new era of inflation, with US inflation increasing from an average of less than 1.5% in the first half of the 1960s to peak at 14.6% in the early 1980s. Policymakers, businesses, and investors all played a role in adding to inflationary pressures over this period:
Firstly, US monetary policy was too easy, with the Federal Reserve (“Fed”) keeping interest rates far below the growth in nominal GDP throughout the 1960s and 1970s, which encouraged inflation. Secondly, businesses also faced significant cost pressures. Over this period, labour had bargaining power as more than 30% of the workforce belonged to a union, which allowed workers to pursue higher wages. Furthermore, oil price spikes caused by Middle Eastern conflicts and OPEC’s new-found market power to control oil supply placed upward pressure on business costs.
Due to the general lack of competition in the economy, businesses passed on the higher costs to consumers by raising prices, thus increasing inflationary pressures. Lastly, the bond market had the power to influence the stance of monetary policymakers; however, bond investors completely underestimated the scale and durability of the inflation upturn.
The inflation era between the 1960s and 1980s was a difficult period for both equity and bond investors. Between the end of 1968 and the middle of 1982, the real total return of the S&P 500 was a negative 33%, while the real return on the 30-year Treasury bond fell 47% – see
Figure 2 – The inflation era was bad for investors
Eventually, inflation became enough of a problem and by the late 1970s policymakers were forced to act. And thus, a new long-run inflation swing was underway, which resulted in the era of disinflation.
The Disinflation Era (1980s – 2020)
By late 1979, US inflation was at 11.5%. This prompted newly elected Fed Chairman Paul Volcker to launch an attack on inflation by hiking the federal funds rate from 10.8% in August of 1979 to 22% by the end of 1980. The cost of this drastic increase in interest rates was a deep recession, but it set in motion a multi-decade period of disinflation.
Volcker was replaced by Alan Greenspan, who continued with the anti-inflation stance by keeping interest rates above the growth in nominal GDP. By the mid-1990s, US inflation was under control, running consistently below the 3% level, even though the US economy experienced strong GDP growth. Reinforcing this disinflation trend were two powerful structural forces: The information technology revolution and increased globalisation.
The US housing market crisis in the late 2000s further exacerbated the disinflationary impulses as the Fed decreased the federal funds rate due to fears of deflation. Over the period from 2010 to 2020, the US inflation rate averaged only 1.7%, failing to reach the Fed’s 2% inflation target.
The multi-decade declines in inflation and accompanying decreases in interest rates triggered the best-ever bull market in financial assets. Between late 1982 and the end of 2019, real total returns averaged an annual rate of 9.8% for the S&P 500 and 7.6% for 30-year Treasury bonds – see Figure 3.
Figure 3 – The disinflation era was great for investors
The implementation of quantitative easing by central banks in response to the Great Financial Recession of 2007 – 2010 would eventually lead to the end of the disinflation era. Over the next decade, central bank balance sheets exploded, and interest rates were kept at unprecedentedly low levels – see Figure 4. Surprisingly, inflation did not increase quicker when considering the excessive monetary policy stimulus and remained at low levels for an extended period. However, it was a matter of time before inflation would increase again.
Figure 4 – Central banks discover quantitative easing
The onset of the COVID pandemic and the Ukraine conflict exacerbated inflationary pressures; however, inflation began to rise years before these events. The pandemic led to supply side disruptions and a spike in demand, which were both inflationary. Furthermore, the Ukraine war added to inflationary pressures via elevated energy prices.
A New Era Beckons (2020 – present)
The drastic return of inflation prompted central banks to hike interest rates aggressively. The average G7 short-term interest rate is at the highest level in more than 20 years in nominal terms and is back into positive territory in real terms – see Figure 5. Central bankers continue to talk tough, suggesting they intend to maintain a restrictive stance until inflation returns closer to the 2% target; however, talk is cheap, especially if we are headed for a recession in 2024.
See Figure – 5 – Central banks have woken up to rampant inflation
The Fed’s latest projections indicated that the US would experience a soft landing in 2024; however, this is a fairytale ending, and anything is possible. If the landing is harder than expected, resulting in a recession, then this would persuade the Fed to cut interest rates much quicker than previously guided, putting an end to the central bank’s hawkish tone and resulting in inflation returning and inflation being higher for longer.
Supporting the idea that inflation may be higher for longer are demographic shifts that suggest that aging populations move from being net savers to net consumers, a process which is inflationary”. Furthermore, the globalisation trend that played an important role during the disinflationary period has eroded, and a more strained geopolitical climate suggests increased trade tensions and less offshoring, providing less relief from elevated inflation.
The above arguments may lead to inflation being higher for longer, placing central banks in a peculiar dilemma. On the one hand, there would be strong resistance to abandoning the current 2% inflation target. On the other hand, central bankers will be reluctant to squeeze down economic growth for a long enough period to keep inflation under control.
A possible outcome is that policymakers will be forced to accept that the economic cost of holding inflation at 2% will be unacceptably high, and a new target between 3% and 4% could be set. That will not be disastrous, but it represents a marked change from the decades up to 2020, when disinflation provided a powerful tailwind to financial assets.
During the disinflation era, low and falling interest rates led to exceptional equity returns via a boost in valuations. As a result, the increase in valuations resulted in two-thirds of the gain in the S&P 500 from 1982 to the end of 2019, whereas growth in earnings only accounted for one-third – see Figure 6.
Figure 6 – The equity bull market was driven more by valuation than earnings
In the absence of rising valuations, market gains will depend on the growth in earnings. Against such a macro backdrop, the earnings generation ability of businesses would thus again become front and centre in capital allocation decisions. The cost of capital and businesses’ fundamentals return as relevant considerations. This speaks directly to value investing – a fundamentals-based investment philosophy. A compelling case in favour of value investing has been created and is building ever stronger. The 2020s might just be the decade of value investing.
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Source: Bloomberg, 31 October 2023