The economist Paul Samuelson once famously said: "When the facts change, I change my mind. What do you do?"
Many economic facts have changed over the past few quarters. In fact, everything I'm witnessing tells me that we are undergoing a paradigm shift in investing. We are moving from a world of benign disinflation to one of higher-trend inflation. From a very low interest rate environment to a rising rate environment. From a long period of low volatility to a period in which volatility will likely be elevated. From globalization to de-globalization, or friend‑shoring, as former Federal Reserve (Fed) chair Janet Yellen calls it. From maximum liquidity to liquidity withdrawal. And perhaps most importantly, from an era of elevated valuations in both equities and rates to one closer to the historical norm (Figure 1).
How can investors respond to this?
Learning the Lessons of History
To understand the present, it sometimes helps to study the past. In the mid‑1960s, for example, inflation began to rise following a long period of generally low inflation. It continued to rise throughout the 1970s and into the early 1980s—a period that became known as the Great Inflation—and incorporated four recessions, two severe energy crises, a lengthy period of stagflation, and previously unseen levels of peacetime wage and price controls.
The Great Inflation lasted until 1982, but the seeds of its reversal were sown four years earlier when Arthur Burns' tenure as Fed chair came to an end. During his eight‑year period in charge, Burns showed little inclination to tackle inflation and was widely regarded as being a political pawn. At President Nixon's behest, Burns cut interest rates just when they should have been raised, fueling a U.S. economic boom ahead of the 1972 election.
Out With the Old, In With the New
(Fig. 1) The paradigm shift taking place in investing
As of August 31, 2022. Source: T. Rowe Price.
Burns was replaced in 1978 by George William Miller, but it was Paul Volcker, who took over as Fed chair in 1979, who really brought about the end of the Great Inflation. Volcker, who understood that the central bank had a vital role to play in tackling inflation, immediately hiked interest rates. This led to the painful 1980-1982 recession and elicited widespread protests as well as political attacks, but it also introduced a new era of disinflation.
There are some parallels today. The current period of inflation, like that of half a century ago, began after a long period of low inflation. And shocks to global energy and food prices made the problem worse in the 1970s, just as they are now. So, are we about to enter another Great Inflation?
This post was funded by T. Rowe Price
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