Upon being appointed United States Federal Reserve chair in 1979, Paul Volcker embarked on a vicious campaign to break the back of inflation, raising rates as high as 20 per cent. His take-no-prisoners approach was largely responsible for the low inflation, declining rates and highly favourable investment environment that prevailed over the next four decades.Article content“Interest rates power everything in the economic universe,” Warren Buffett once said. “They are like gravity in valuations.
The impact of the one-two punch of higher earnings and higher valuations unleashed by decades of falling rates cannot be overestimated. Stocks had an incredible four-decade run, with the S&P 500 index rising to 4,796 by the beginning of 2022 from a low of 102 in August 1982, producing a compound annual return of 10.3 per cent.
The good news is that inflation will probably abate as pandemic-induced savings are spent and disrupted supply chains are mended, providing central banks cover to taper and eventually cease their tightening campaigns. The bad news is that the deflationary influence of globalization, which kept inflation at bay in the face of historically accommodative monetary policies, is slowing or reversing.
Put another way, the economic backdrop for asset prices will be less favourable than the Goldilocks environment that prevailed from the early 1980s to the end of 2021. It’s one thing for 10-year U.S. Treasury yields to have declined approximately 1,500 basis points to less than one per cent during the pandemic from about 16 per cent in 1981. It would be an entirely different affair for them to fall to -11 per cent from their current level of almost four per cent.
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