No Pain, No Gain

What has happened in the stock markets over the past three years shows how
important interest rates and oil prices are. Global economies experienced the
first ever voluntary economic shutdown as Covid-19 swept over the world in
2020. Stock prices cratered by 35% for six weeks in the first quarter of 2020
but confounded many as stock prices rebounded to all time highs the third
quarter of 2020. How could that happen? The main reason stock prices were
strong was that the US Federal Reserve, the Bank of Canada and other central
banks around the world took drastic measures which included lowering interest
rates close to 0% in order to keep economies going. It worked. (Chart from WSJ)

The price of oil and other commodities collapsed in 2020, which also lowered
costs for consumers and businesses. Then the price of oil and other commodities
rose sharply in 2021 as global economies recovered while many businesses were
still affected by Covid outbreaks and workers calling in sick. Many companies
could not produce like they did before Covid, which caused a shortage and/or
rising prices for many goods and services. Inflation had been low for many years,
but this caused inflation rates to rise. In 2021, oil prices rose more than 80% in a
12-month period, meaning that stock prices could fall 20% or more sometime in
the next 18 months or so. Stock prices are usually strong from November to May
so I expected stock market weakness would occur right about now, starting in
September 2022.

However, the Russian invasion of the Ukraine on February 24, 2022 changed
all of that. Military invasions are not usually a major negative force on stock
prices. One of the reasons that the Ukraine was such an attractive target is that it is
rich in resources. The economic repercussions of this invasion were much greater
for two reasons. First, the invasion itself reduced the supply of commodities,
which in turn caused many prices to rise. This led to much higher inflation. The
second economic repercussion was another unusual impact of this invasion. In
response to the cruel nature of this invasion, countries all over the world wanted
to stop buying and shipping Russian oil and natural gas. This led to supply
shortages and even higher oil prices and rates of inflation until more oil could be
provided by other countries.

As a result, for the first time since the 1970’s, the Fed and other central banks
have had to pivot to fighting inflation in 2022. How do you fight inflation? By
raising interest rates to reduce economic growth and the demand for commodities.
However, it isn’t that simple. The Fed, investors, homebuyers and business
owners learned a most painful lesson fighting inflation from 1980 to 1982.
Anyone who lived through those years will never forget it. Some young couples
and business owners were scarred for life as they became the casualties of the war
against inflation. What was the lesson learned?

Before talking about the lesson learned, it is important to understand that
conditions today are not nearly as bad as they were in 1980. By 1980, oil prices
had appreciated from $4 a barrel in 1970 to $38 a barrel. Rising inflation had
become firmly entrenched in the economy after rising steadily for more than a
decade with no end in sight. For example, President Nixon tried to stop inflation
by imposing a freeze on wages and prices for 90 days in 1970. In the 1970’s,
saving up money to buy something didn’t make sense anymore. By the time a
person had saved up enough money to buy what they were saving for, the price of
what you wanted to buy was much higher and beyond reach. This encouraged
people to save less and borrow more. This mirrors what has been happening to
real estate prices in the local economy for years now.

Strikes by workers became commonplace as they demanded higher wages to
compensate for the higher cost of living. This was referred to as a wage and price
spiral. By 1980, high and rising rates of inflation were not just a normal part of the
economy, they were engrained into the mind of the public. There was the belief
that inflation would just go higher and higher and never end. Central bankers
knew this would end badly if it carried on.

Paul Volker became the Chairman of the Federal Reserve Board on August 6,
1979 and pushed for major action to tame prices and wages. The Fed Funds rate
jumped from 10% in October 1979 to 20% in April 1980 to shock consumers and
the economy. The US economy went into a recession by January 1980.
(Please see a chart of the US inflation rate below.)

After putting this “chokehold” on the economy in early 1980, the Fed lowered
the Fed Funds rate to 10% by mid-1980, hoping that this would be enough to
eliminate the inflationary psychology. As 1980 progressed, it became painfully
clear that this strategy did not work. High inflation rates and the inflationary
psychology remained. See the chart of the US Fed Funds rate below.

 

If you look above 1980 on the chart above, you can see the brief spike in
interest rates in early 1980 up to 20% followed by the sharp fall back down to
10% in mid-1980. Since this relatively short spike in interest rates did not work,
the Fed was forced to “strangle” the economy not only by raising interest rates to
extremely high levels, but by keeping them there for long enough to ensure that
people would believe that high inflation was a thing of the past. Canadian real
estate prices suddenly fell off a cliff in January 1981 as sales stalled. Interest rates
remained high in 1981 and early 1982, putting global economies into a severe
recession. Unemployment skyrocketed and hundreds of US companies were
declaring bankruptcy every week. I remember that most of the men my age who I
knew in 1982 were out of work. Many young couples who had bought a home
when interest rates were at 10% in the late 1970’s lost their homes as they could
not afford to pay interest rates of 20% for so long. Charts do not convey the
despair, fear and losses that were sustained by many over those years. It was very
similar to what happened in the U.S. during the Financial Crisis in 2008 to 2009.
That was the bad news.

The good news was that this tough medicine did eliminate the inflationary
psychology and high rates of inflation. It set the stage for one of the strongest
periods of US economic growth from 1982 to 2000. This, together with falling
interest rates, also enabled US stocks to skyrocket from 1982 to 2000. The S&P
500 rose by 20 times over this 18-year period if dividends were reinvested!

Although Paul Volker seemed like a heartless enemy to many, he, together with
President Ronald Reagan and others only did what had to be done to create the
prosperity many have enjoyed ever since 1982.

The lesson that was learned 40 years ago was that lowering interest rates too
early will not beat inflation. It is better to raise interest rates and keep them at a
higher rate until there are clear signs that the rate of inflation is declining in a
meaningful way rather than lower them too soon. If rates had been kept higher the
first time they were increased to record high levels in early 1980, the 1981-1982
recession might not have been so severe.

The current Fed Chairperson, Jerome Powell, mentioned Paul Volker and the
lesson learned in a speech today and stock prices fell 3%. Stock prices had
rebounded since mid-June, partly on hopes that a peak in interest rates might be in
sight soon. Powell’s comments today made it seem that it may take a longer time
than expected to see lower interest rates.

However, it is important to remember that this is the role of a Fed Chair at a
time like this. He is not just dealing with the economy. Powell also wants to get
the message into the mind of the people that he will be tough on inflation until it
comes down, no matter what it takes. He wants investors to know that he is well
aware of Paul Volker’s actions and the lessons that were learned from 1979 to
1982. He knows any pain suffered in the near future by leaving interest rates at
this level for long enough and talking tough will be worth it. The consequences of
not being tough enough now are much worse!

While Powell is assuring everyone that he will do what it takes to beat
inflation, the Fed will be reacting to data in the months ahead. According to AAA,
the average price of gas in the US is now $3.86, compared to $4.30 a month ago, a
drop of 10.2%. The peak was close to $5.00 a gallon a few months ago. The price
was $3.15 a year ago, so gas prices are still 18.4% higher year over year. Natural
gas prices are still at high levels as western Europe has plans to wean itself
completely from Russian energy by 2030.

This is increasing the push to green energy, which I believe is one of the major
drivers of growth in this 16 to 18 year cycle. As an example, German Chancellor
Olaf Scholz was in Canada this week forming an agreement to transport green
hydrogen from the east coast of Canada to Germany. The use of hydrogen and
green hydrogen offers one of the best ways for countries to meet their emission
targets for the future.

When we listen to what central bankers are saying at a time like this, we must
remember what their goal is. They can accomplish a lot by talking tough instead
of just acting by raising interest rates. The tough talk yesterday seemed to have
accomplished its purpose. Even so, it may not change what will actually happen to
interest rates. The US 2-year bond yield provides a good guide to where interest
rates might be in the future. The rate peaked at 3.42% in mid-June and has traded in
a range between 3.4% and 2.8% over the last two months. Today, the yield is at
3.392%, near the high point of the range again. This would imply that the Fed would
have to raise interest rates by another 0.90% from the current level. As mentioned,
inflation data in the coming weeks will likely be the driving force behind any future
interest rate moves. (Chart from MarketWatch)

 

The yield curve for the 3-month T Bill vs. 10 Year US bond is still barely positive at
0.15%. This has been a good indicator for predicting if the US economy will go into
a recession. If it can remain above 0%, it will indicate that the U.S. economy will
not go into a recession.

In conclusion, the events of 1980 to 1982 taught everyone an important lesson.
The lesson was that interest rates should not be lowered too soon. It is much better
to keep rates high until it seems that inflation is under control rather than lowering
them too soon. Some pain for a prudent amount of time now should pave the way
for gains and a much healthier economy in the future.

Many who are active in the markets and the economy today may not be aware
of what happened in early 1980. It is good that the Fed has learned this lesson so
that we may not have to repeat what happened in 1981-1982 again.

It is important to note that high inflation is not entrenched into the economy
and the mindset of the public as it was in the 1970’s. High inflation today is
caused by a sudden perfect storm of events over the last two years that are
unlikely to be repeated for a very long time. This means that the Fed and other
central banks should not have to take drastic action like they did in the early
1980’s. Tough action and tough talk now are the right steps to take in order to
lower inflation to acceptable levels as soon as possible to create a strong and
vibrant economy in the future. A strong and vibrant economy is what creates the
perfect conditions for rising stock prices.

 

I recently took a visitor from Ontario up to the top of Mount Cheam (elevation
6,912 feet or 2,104 metres) on a spectacular, clear day. Please see a photo of Lady
Peak just to the northeast of Cheam and another photo looking north to the Fraser
River and the Harrison Lake area on the next page. Have a great week my friend!