For some of us of a certain age, an event from four decades ago is often remembered more vividly than what happened four weeks or even four days ago. Such is the case with August 17, 1982. It arguably marked the birth of the great bull market in stocks, stretching into the next century.
The catalyst came from a dramatic turnaround by Henry Kaufman, then Salomon Brothers chief economist, arguably the most powerful bond dealer at a time when interest rates had soared to previously unimaginable levels. Known as Dr. Doomed by his influential and prescient predictions of rising inflation and bond yields in the 1970s, Kaufman’s shift from making bleak predictions sparked a bullish rush.
When Barron’s caught up with him over the phone over the past week, the underage sounded as sharp as ever, remembering the markets and policies of the past and juxtaposing them with those of the present with equal candor.
As for 1982, Kaufman said he made his bullish call after assessing changes in the economic and market environment during a trip to Europe. Yields had peaked in October last year, when long-term US Treasury yields hit 15%. Inflation declined and credit demand declined, while the economy remained in recession, the second of the successive downturns of the early 1980s.
However, inflation remained high and he characterized monetary policy at the time as ‘relatively tight’, which might come across as understatements to current observers. The consumer price index fell from its double-digit peak to around 7%. Core inflation, excluding food and energy, was 8.5%.
But the Federal Reserve’s policies then aimed at controlling the money supply rather than interest rates still resulted in interest rates well into double digits, although it was in a downward trend from the beginning of the spring. mid-teens. Cracks also began to appear in the financial system, first with the failure of an obscure government securities dealer in May, then with a Mexican debt crisis in August.
Kaufman’s Reversal – Which He Recorded in His Book The day the markets roared, released last year, sparked dramatic rallies in bonds and stocks, which he attributed to the markets becoming accustomed to his previously long-held bearish views. It’s hard to describe how astounding his changed mind was then, long before the Internet or even financial TV channels existed. It was also a time when the Fed tried to cover up its policy intentions rather than steer the markets.
But the contradictions between then and now are even more fundamental. Real interest rates are very negative today, well below inflation, Kaufman notes. That’s whether measured by the 9.1% year-over-year rise in the CPI or, most charitably, the 4.8% rise in the personal consumption deflator, the Fed’s preferred metric.
Furthermore, the central bank’s approach is fundamentally different, notes Kaufman. Current monetary authorities prefer to act incrementally, as opposed to the bold action taken by the Volcker Fed in 1979. The current Fed in particular has not acted quickly to reduce liquidity by shrinking its balance sheet. Instead, it continued to buy Treasury bills and mortgage-backed securities as inflationary pressures mounted last year, particularly in the housing market.
“Today you have a man with much milder behavior who is not aggressive on monetary policy,” said Kaufman, referring to Fed Chair Jerome Powell.
The character of the policy-making Federal Open Market Committee has also become less confrontational, with few dissent, he further notes, in contrast to the disagreements observed during the presidency of Paul Volcker and his successor, Alan Greenspan. Kaufman also speculates on the influence of Treasury Secretary Janet Yellen, Powell’s predecessor as Fed leader. Trained as a labor economist, she is more prone to easier policies to support jobs than to more difficult policies to curb inflation, he says.
All this leaves the markets in a rather different place than they were four decades ago. By then, the economy had already gone through the monetary wringer and two recessions to bring inflation below 4%. By contrast, the Fed only started raising interest rates last March, to just 2.25%-2.50% ahead of its near-zero Fed fund target, when it was still expanding its balance sheet to inject liquidity.
Even relatively aggressive officials are suggesting that the key rate could rise to 4% in 2023, which would put it not far above their 2.6% end-2023 expectation for PCE’s core deflator (with only a small rise in unemployment, up to 3.9% by 2023). then), according to the FOMC’s most recent Summary of Economic Projections.
Kaufman expresses little confidence that the central bank will quickly return to its previous inflation target of 2%. Instead, he proposes that the monetary authorities hesitate before reaching that goal. In other words, if 1982 was the beginning of the end of the inflation war, we are not even at the Churchillian end of the beginning.
So how can government bond yields below 3% be explained, with the 12-month CPI lagging above 9%? Kaufman attributes this to a feeling that the effects of high oil prices and the war in Ukraine could resolve themselves.
He also points to the short-term mentality of institutional investors. They have a trading orientation based on what he calls the illusion of the high tradability of their assets when they want to sell. That assumption was severely tested during the pandemic-induced upheavals of March 2020. In addition, he adds, credit quality has deteriorated during the market cycles of the past few decades.
That said, Kaufman says it’s clear that the US will be the first to emerge from the effects of the pandemic and will be much better served than Europe or Asia.
So, what should readers do with their wallets? Kaufman protests, pleading that he has no acute knowledge when it comes to stocks. As for fixed-income investments, he says that if you have to buy bonds, he prefers municipalities, which offer tax-free returns that are higher than taxable counterparts, provided you do the required credit analysis.
Forty years later, Kaufman may no longer be Dr. Doom, but he still retains his signature caution.
Write to Randall W. Forsyth at [email protected]