I Wear the Chain I Forge in Writing
My children are home. The stockings have been hung with care. The holidays are nearly here. You could cut the tension in my house with a butter knife. Bah, humbug! And here I sit wearing the chain I forge each month in writing Uncommon Sense -- word by word, sentence by sentence and paragraph after paragraph; I gird it on of my own free will, and of my own free will, I write it. After December, thankfully, there will be no more silly Uncommon Sense holiday lampoons. It’s back to serious investing business next month. For the fifth straight year, January’s article will identify three surprises for investors in the coming 12 months. But in the meantime, this Ebenezer Scrooge will playfully visit with the Christmas ghosts of markets past, present and future.
Shadows of the Inflation that Has Been
In Charles Dickens’ A Christmas Carol, the first spirit to visit Scrooge is the Ghost of Christmas Past. Together they visit Christmas scenes from his childhood. If I were playing the part of Scrooge today, the Ghost of Christmas Past would transport us back to my early childhood in the 70s - not the 1870s, wise-guy, the 1970s. The stock market was a catastrophe. Economic growth was weak and unemployment was rising, eventually reaching double-digits. The US Federal Reserve (Fed) responded with easy monetary policies that were designed to repair the labor market. Disastrously, by the early 1970s, accommodative monetary policy resulted in high rates of inflation. Multiple oil crises, powerful labor unions, and currency speculators added additional fuel to the inflation fire. Year-over-year inflation peaked in 1979, at more than 13%.
Perhaps former Fed Chairman Paul Volcker would be cast as the Ghost of Christmas Past in our capital markets Christmas tale. After all, those that don’t learn from the past are doomed to repeat it. Isn’t that the lesson that the spirit is trying to teach Scrooge? Immediately following his appointment as Fed Chairman in August 1979, Volcker aggressively raised rates to defeat inflation. The Fed funds rate reached a whopping 18% in 1980. For interest rate-sensitive industries such as housing and autos, rising rates were devastating. Many Americans simply could not afford new cars and homes. By 1982, inflation had been tamed and rates slowly began to stabilize. This paved the way for a lengthy economic expansion and bull market.
Many economists and market observers were fearful that today’s easy monetary policies would result in high rates of inflation, too – a 1970s repeat. So far, those fears seem wildly overestimated. Nearly all measures of inflation remain stubbornly and persistently below the Fed’s 2% target, providing ample room to keep rates low and financial conditions easy. This has undoubtedly supported financial asset prices.
America’s burgeoning energy independence and the waning influence of labor unions combined with structural headwinds, such as debt, demographics and technology, are likely to keep inflation dormant for a good while longer. However, an inflation scare in 2020 is possible. West Texas Intermediate (WTI) crude oil prices have climbed 34% year to date.1 Labor is capturing a growing share of business output in a tight jobs market. And the Fed has practically said it would welcome higher prices. A 1970s replay isn’t likely in the cards, but an inflation scare may spook investors into concluding that the Fed will begin raising rates again by the end of 2020, putting downward pressure on already lofty valuations.