“The secret to change is to focus all your energy not on fighting the old, but on building the new.” (The Way of the Peaceful Warrior, by Dan Millman)
As a fledgling strategist in the early 1980s, I vividly remember some of the statements I received from the gray-haired portfolio managers I worked with: “Never pay the growth rate more than once income from a share.” ; and “Don’t buy stocks until dividend yields are higher than bond yields.”
At the time, the DJIA had just passed 1,000, territory it hadn’t seen since the 1960s. The average daily trading volume on the NYSE was less than 100 million shares. Retirement 401(k)s hadn’t really been invented yet and held no assets. Less than 5% of the population owned stocks and the DJIA traded at around 7 times its earnings. Dividend yields, especially on food, consumer staples and healthcare companies, were consistently around 5%. And, as investors had learned, dividends were how they should be compensated for the risk of owning stocks, versus the reliability of fixed income coupons.
The 1970s were brutal for fixed-income and equity investors with double-digit inflation, commodity turmoil, cost-controlled wage/price spirals, and regulated industries as far as the eye could see. A huge stock market rally and simultaneous IPO boom in the fall of 1982 caused many disbelievers. The common lore, in fact, was that double-digit interest rates were here to stay and oil would hit $150 a barrel before stabilizing.
We know in hindsight that most of these statements did not materialize and that the next 40 years would usher in unprecedented booms in the stock and bond markets. Now, as a long-time observer of market action and behavior, the question that plagues me these days is: Are we on the brink of a new shift that will upend many of the relationships that have dominated these last decades ? Time will tell us. But there are many aspects worth watching and carefully considering when it comes to portfolio construction, corporate finance, and our own financial affairs.
Interest rates, prices and inflation
Markets saw significantly increased volatility at the start of 2022 as investors recalibrated their expectations of sustainable inflation versus transitory inflation and a (much) more hawkish tilt towards US Fed policy. While the Fed was expected to start raising rates later in 2022, the persistence and strength of economic numbers, supply chain shocks, strong consumer demand and rising commodity prices pushed them to express the likelihood of a quicker balance sheet liquidation and earlier rate hikes. by early January. Growth investors who had become accustomed to thinking that low rates would support valuations far into the future were quickly recalculated, knocking previously high-flying names down by high double-digits. Sectors and companies perceived as benefiting from rising interest rate environments and/or displaying more defensive characteristics (utilities, basics, financials) held up better.
Investors’ shift in sentiment towards Fed hikes has not trickled down the curve in fixed income markets. While shorter denominations rose (especially 5- and 10-year bonds), the long end of the curve remained relatively stable and spreads over high yield did not widen unduly. This suggests that investors have a more optimistic attitude towards long-term inflation. As prices rise (and in places unlikely to reverse quickly, such as rents and wages), the rate of change should stabilize.
Result for investors? Get used to somewhat higher price points for many things than we were used to in the recent past. But a return to the inflationary spirals of the 1970s does not seem likely. As consumers and investors, we have become extremely accustomed to zero short-term rates. Our current return to a more normalized level in the lower single digits may hurt at first, but there are plenty of individuals (long-term savers), workers (who may see wage increases above 0- 2%) and companies (which now have some pricing power) that can be beneficial in the long run.
The inflationary/deflationary cycle
Nearly three quarters of the US economy is based on consumer spending. Until the pandemic, much of this spending was on services (restaurants, concerts, haircuts, education, training), with much of the manufacturing activity moving overseas and sellers on all sides relying on just-in-time inventory. . The shift to relocation had begun long before the pandemic, but a drastic shift from services to goods (home office, workout equipment, new sofas, kitchen tables, grills) has thrown sand into the gears of a chain already fragile supply.
The boom and bust cycles of the 1970s were often exacerbated on the upside and downside by a society that was more dominated by manufacturing than the one that exists today. As we relocate more manufacturing (thanks to tariffs, supply chain disruptions, a desire to bring critical infrastructure back to the United States, and a new intent to bring manufacturing closer to the consumer), will the pendulum swing back? it to a more manufacturing society? ? If so, there’s a chance we could reintroduce the more volatile economic swings of the 1950s, 1960s, and 1970s, which relied on inventory buildup and decline. We are a long way from that and the deflationary impacts are plentiful (particularly technological advances and more efficient manufacturing techniques), but the trend is worth watching from the margins.
Altogether, the last few years have changed a lot of what we thought we knew about consumer, business and investor behavior. Keeping an open mind about how the new normal emerges will be key to helping us maintain our collective footing in the quarters and years to come.
Carol Schleif is Associate Chief Investment Officer at BMO Family Office, a wealth management advisory firm that provides investment management, trust, deposit, and lending products and services through BMO Harris Bank. To learn more, visit www.bmofamilyoffice.com.