Since 1950, the dramatic developments of the U.S. economy and financial markets can be explained in terms of what happened to the level of real interest rates. Of course, there have been many other factors at play. There have been wars, changes in government policies from smaller governments to bigger governments, and an increase in the welfare state and many, many other reasons. Quite often it is easy to be misled by headlines sponsoring specific ideas and specific political trends. Sometimes it seems appropriate to have a government leading more towards a welfare state where the government is the caretaker of the problems of the citizens, from insurance, medical assistance to daycare and so on. But all these trends have a price and the politicians, or for that matter no one, knows when to stop. The only time people recognize that they have to stop is when the problem has been created and is so big that it has to be solved.
The typical example is what happened in the 1970s in the United States. The trend of the 1970s was to provide more assistance to the citizens and the government tried to satisfy those needs. At the same time, the United States was also involved in a war. It was difficult for the average person to recognize what was happening, and difficult for the average citizen to evaluate the impact of certain decisions when the commitment was not to raise taxes - although there was a commitment to fighting a war and implementing what used to be called the Great Society. Inflation was the only solution. But the average investor needs to have an impartial framework to assess and develop an investment strategy.
The investor needs a precise number and something to follow to make decisions. The only number that can accurately depict what has happened in this century is the level of real short-term interest rates, which has been mainly driven by the policy of the Federal Reserve. Clearly in the transition from the 1960s to the 1970s the average investors would have realized that something was happening when gradual inflation kept rising and real interest rates started to decline. As inflation began its decade long rise, the dollar slowly and steadily began to weaken.
Because of the very close relationship between real short-term interest rates and long-term interest rates, the analysis will be based on real short-term interest rates. In the 1970s when real short-term interest rates declined sharply below 1.4, it was a clear signal for the investor that the seeds for an inflationary environment were planted. As we said above, inflation in this century has been stable when real short-term interest rates were kept close to 1.4 or above this level. The only time inflation rose sharply is because real short-term interest rates declined below 1.4.
The impact of real long-term interest rates will be discussed in the chapter dealing with investments in bonds. It will provide valuable information on how to determine when bonds become a good investment.
Dr. Henry Wallich, a governor of the Federal Open Market Committee in the 1970s, often noted that real short-term interest rates were too low in the 1970s, even at a time when short-term interest rates soared from 3% in the late 1960s to 20% in 1982. His point was money was too cheap and it would be inflationary for the reasons discussed in the previous section. Of course, the Fed could not raise real short-term interest rates because cheap money was necessary to finance the "Great Society" and the war in Vietnam since the government did not increase taxes to finance both efforts.
In order to fight inflation the Fed let interest rates rise in 1968, causing the recession of 1969-1970. Inflation declined because of very slow growth in the economy, but money was still kept cheap, as real interest rates were kept low.
The next expansion, which started toward the end of 1970, saw inflation rising from 4% to 6% from 1972 to 1974. Worried that rising inflation might go out of control, the Fed let interest rates rise again in 1972, causing the recession of 1973. Again, inflation declined from 6% to 4% because of slow economic growth. However, because of very low real short-term interest rates, the next expansion was accompanied by even higher inflation, which soared to 15% in 1982.
The lesson of the 1970s was that low real short-term interest rates were accompanied by soaring inflation and a very volatile economy because the Fed had to induce a recession every two years to try to keep inflation under control (Fig. 5-1). Commodities soared with the price of gold rising from $35 to $800 and crude oil from $25 to $40. Wages jumped because of rising inflation, and also due to lower productivity. As a result, unit labor costs (the difference between wages and productivity) rose rapidly. Not surprisingly, corporate profitability was dismal. The dollar, which reflected soaring inflation and poor economic conditions, collapsed from 3.20 German Marks to the dollar to only 1.50 German Marks to the dollar. The Yen also soared relative to the dollar from 340 Yen to the dollar to just about 85 Yen to the dollar.
While returns from hard assets were simply fantastic as prices of commodities, such as gold, crude oil, industrial metals, real estate, and just about anything soared, the returns from investments in financial assets in the 1970s were dismal. Bond prices collapsed as yield on 10-year Treasury Bonds soared from 5% to 15%, and the stock market finished in 1982 at the same level as it was in 1968, mirroring the dismal performance of the profitability of corporations.
Clearly, the 1970s were a very special decade and provided important lessons. The 1970s experienced extreme business fluctuations as inflation rose from 3% to 15%. Business cycles were much more stable in the 1960s and after 1982 as inflation declined back to 1960 levels.
The 1970s were characterized in the following terms:
• Low real short-term interest rates below 1.4%.
• Rising inflation.
• Rising commodities.
• High volatile economic cycles.
• Dismal productivity growth.
• Corporations could raise prices because of rising inflation to improve profitability.
• Low investment in technology.
• Soaring real estate and land prices.
• Soaring long-term interest rates.
• Sagging bond prices.
• Frequent protracted declines in stocks with prices going nowhere from 1968 to 1982, or 15 years.
The dollar also sagged, reflecting a US economy in total disarray. In the 1970s, the decline in the dollar made foreign investments particularly attractive, thanks mostly to the strength of European and Japanese currencies.
If the investor looks at the years 1955 to 1968 and the years following 1982, the most crucial feature is that real short-term interest rates in this period were kept well above 1.4. In the years following 1982, they were considerably above their long-term average. By making money expensive in real terms, the Fed forced consumers and business to become wiser in their spending and their investments (Fig. 5-2). As inflation declined, business could not raise prices at will. In order to improve profitability, they had to enhance productivity (Fig. 5-3).
Inflation soared in the 1970s as real short-term interest rates were kept below their historical average. Inflation was low in the 1960s and after 1982 as real interest rates were kept above their historical average.
Due to declining and low inflation after 1982, business lacked pricing power to improve margins. Consequently, corporations relied on enhancing productivity as a way of absorbing costs and raising profitability. As a result, since 1982, the U.S. enjoyed soaring productivity growth.
This could be done by restructuring and with heavy investment in technology. It is no coincident technological development boomed after 1982 and was stagnant in the inflationary 1970s. Technology stocks also soared as new technologies were introduced.
The lesson is that as long as real interest rates stay high, and inflation low, technology stocks will continue to perform well. As productivity soared, unit labor costs remained stable, even if wages were growing at a 3% or 4% pace. At the same time, inflation and higher productivity were accompanied by a stable economic environment with only one minor recession in 1990-1991, mostly induced by the consumer panic over the Gulf War with Iraq. As inflation declined after 1982 from 15% to 2%, 10-year bond yields dropped from 10% to 5% and stocks soared. Low inflation also meant lower commodities with gold declining from $800 to $300 and crude oil from $40 to $15. Real estate, reflecting the slower growth in inflation, did not display the phenomenal price increases of the 1970s. Financial assets were the great performers. Hard assets such as precious metals performed poorly - exactly the mirror image of the 1970s.
There is only one period when this great economic environment was disturbed. In 1992-1993, because of the real estate and savings and loan crisis, the Fed had to make money cheap to protect the U.S. economy and improve bank profitability by keeping the yield curve unusually steep. It did so by keeping short-term rates very low relative to inflation. This easy-money period was briefly followed in 1994 by the type of environment typical of the 1970s: rising inflation and bond yields, weak stock prices, soaring commodities, and a weak dollar.
The 1950s were in many respects similar to the years that followed 1982. Real short-term interest rates were kept above the historical average of 1.4. Inflation as a result was around 3%, bond yields were stable, the stock market was strong, and the dollar was the currency of choice. Gold was trading at $35 and the economy had two mild recessions. Financial assets were definitely a solid investment. Both bonds and stocks provided superb returns from 1982 as inflation declined, while hard assets such as precious metals and real estate did not perform as well as stocks and bonds.
It is very difficult to find a single indicator that can best give a sense of the economic times facing the investor. Real short-term interest rates are the only indicator that, with its simplicity and easy availability, explains the huge transition that took place from the 1950s through the 1970s and the years following the years 1982.
(From Chapter 5 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).
George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager
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