The last six months have shown that the absurdly loose Fed policy and benign monetary conditions have gone – the 39-year bull market in bonds (1982-2021) is over. Inflation will not disappear soon, and the Fed will not raise rates far enough to control it, but the next decade or more will inevitably see a bear market in bonds and in asset values. We have forgotten what those deflationary markets are like, so I thought it worth setting out some pointers.
There are three periods that seem especially pertinent to the decade ahead: the 1880s, the 1930s and the period of rising interest rates from 1965 to 1981. The behavior of consumer prices differed between the three periods according to the monetary regime in force. The 1880s, during a Gold Standard period, were genuinely deflationary, with prices falling around 20%. The 1930s, during which the Gold Standard was abandoned and a mildly reflationary Fed policy followed, showed little price inflation once the initial recession had passed. In the 1970s, a period of fiat money and loose policy, inflation accelerated with the Fed making futile efforts to rein it back, until the final successful effort in 1979-82 after Paul Volcker’s appointment as Fed Chairman.
This time around, actual consumer price deflation seems unlikely. We do not have a Gold Standard and are not going back to one in the short term. The Fed is attempting to raise interest rates far enough to curb inflation, but is hopelessly far behind the curve, so much so that inflationary psychology will surely perpetuate current rates of inflation (or increase them) long before the Fed has raised rates sufficiently to curb it. However, the current deflation in asset values is unlikely to reflect the 1970s precisely, since that decade saw no really serious depressions, and was not preceded by a period of massively overvalued asset prices. 1880s and 1930s experiences (which followed the bubbles of 1873 and 1929) are thus also relevant.
Deflation in the next decade will occur primarily in asset prices, which have been grotesquely over-inflated by decades of easy money and a succession of bubbles that were never allowed to burst properly, cleansing the “malinvestment” that had taken place. Both in 2002 and in 2009, the stock market turned around unnaturally quickly as the Fed pumped money frantically into the economy. Naturally, this merely resulted in further economic costs – many companies that should have gone bankrupt were enabled to stagger on, earning subpar returns and refinancing their debt, thereby imposing further costs on the economy. It must surely be clear, for example, that a great deal of economic cost would have been avoided if Sears had gone bankrupt in say 2003 rather than 2018, thus not absorbing billions of dollars in debt and not providing billions of dollars in unwarranted gains for its private equity speculator owner?
With three lots of half-digested “malinvestment” to absorb, the devastation of the next decade will be gigantic. Precisely what form that devastation will take is at present unclear. Theoretically, the Fed could act quickly to raise interest rates to their necessary level above inflation, ignoring the possibility of developing a recession in the economy; in that case the devastation would all occur at once as it did in 1929-33 or 1920-21.
The advantage of this course is that it would reduce the long-term damage; if President Hoover had not worsened the 1929-33 downturn through Smoot-Hawley and his income tax increase, and FDR had not hugely prolonged it with his planned-economy meddling, that recession would have been only moderately deep and over quickly. As justification for that statement, I would remind you of the 1930s trajectory of the United Kingdom, whose economy, blessed with sound policies under Neville Chamberlain, turned around in mid-1932 and then enjoyed an unprecedented boom until the shadows of war drew near. A rapid, thorough recession, with policies aligned to restore economic order, is a good recession.
It is most unlikely that the Fed will do anything so sensible. Instead, it will back off and lower rates again when the first signs of recession appear, which will not eliminate the recession (government statistics appearing well in arrears of the reality, and monetary policy effects having a further lag) but will cause inflation to accelerate. Only after several cycles of recession and inflation acceleration will the Fed, probably with a new Chairman, raise rates properly above the level of inflation.
This will cause the malinvestment bankruptcies to come in waves, with each new wave further devastating economic activity, increasing unemployment, reducing business confidence and preventing economic recovery. The overall effect will be more severe than one all-encompassing downturn, because premature optimists who buy at intermediate bottoms will themselves be wiped out.
That is the picture in general. The picture for particular sectors will vary, because of the differential effects of inflation and interest rates that, while generally rising, are still below the inflation rate. Residential real estate, for example, will not suffer too badly; in the 1970s house prices generally continued rising and this will also be the case this time around, at least for real estate outside the major metropolitan areas. The bankruptcy levels in the sector will thus be moderate. The exception will be the high-priced real estate that has been bid up to a premium in big cities; in New York, for example, there will be few wealthy domestic buyers, because of the tax rates, and fewer foreign buyers, because of the crime; the result will be a sharp fall in values of “trophy assets” with accompanying bankruptcies for those who have lent too much against those assets. Retail and premium office real estate will also be hard hit, because of a deep slump in demand through recession and structural market changes; the prime skyscrapers of Manhattan, all new in the 1930s, suffered prolonged periods of under-occupancy and mostly went bankrupt.
In equities, the picture will be less mild. Investors will expect a repetition of the 1970s, when stock prices remained flat in nominal terms between 1966 and 1982, while declining by three quarters in real terms, but the stock price overvaluation in 1966 was nothing like as extreme as in 2021, and interest rates both nominal and real were much more reasonable. Hence, we can expect a decline in nominal terms like that of 1873-79 and 1929-32, although not quite as severe as the 88% drop in 1929-32, because inflation will cushion the bottom and corporate earnings are unlikely to disappear altogether as they did in 1932. The consumer tech sector will be especially badly affected, partly because of its 2021 overvaluation and partly because as advertising spend declines in a recession, companies like Alphabet (NASDAQ:GOOG) and Meta Platforms (NASDAQ:META) will be severely hit, losing their monopolistic profit positions.
Whereas real estate, if not already overvalued, will be cushioned by inflation, bonds will suffer a double whammy, as their prices decline with rising interest rates while the value of their principal is eroded by inflation. The experience of British government 2½% Consols, priced around par in 1947 and at 16% by 1974, which 16% was worth about 3% of their original principal value, will be typical. There will be a further effect as real yields rise faster than nominal yields; Treasury Inflation Protected Securities (TIPS) which one would expect to be an excellent investment in an inflationary era, have so far been a rather poor one, as their “real” yield has risen from negative 1.5% to around zero. As for “junk bonds” the additional threat of bond defaults in an era of declining credit quality will give them a unique triple whammy of negativity that means they should be avoided at all costs. (Yes, Michael Milken did very well from junk bonds, but they were already bombed out by 1974, when he started trading them.)
Private equity funds that can stay in cash until the competition has collapsed will do well, naturally, but currently there is far too much money chasing after deals that will lack an exit in the next decade’s depressed stock markets – not a recipe for success. Farmland will suffer as it did in the 1880s; crop prices will decline and mortgages become increasingly burdensome as land values fall back from their recent highs.
Just as the last three decades of inflation and rising asset prices have provided investors with a false sense of riches, as their wealth has soared far beyond the dreams of those who have to work for a living, so the next decade will see the reverse effect. For the majority, us poor slobs for whom the majority of income comes from what we earn by the sweat of our brows, that may be very good news indeed, once the first pain of the recession has passed.
It’s a pretty tatty silver lining, but the only one I could find.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)