Inflation, Rates, and the Markets: 1980s versus Now

The last time inflation was this high and rates were rising, Ronald Reagan was in the White House, Olivia Newton-John was all over the radio, and the cool new computer was the Commodore 64, named for its 64 kilobytes of memory. Oh, and a new soft drink (New Coke) was about to hit the shelves. In the 1980s, annual inflation peaked at 14.6%—almost twice as high as it is right now. Richard Nixon, Gerald Ford, and Jimmy Carter had all been dogged by high inflation, so by the time Reagan came into office, Americans had become numb to prices that just kept going up. In 1979, inflation was 13.3%, and in 1980 it was 12.4%. So, compared to the 70s and early 80s, today’s inflation rate doesn’t look that bad.

How did policymakers get control of inflation back then?

Well, the Federal Reserve administered some painful medicine. Paul Volcker, who was appointed Fed chairman by then-President Carter, was determined to break inflation’s back, and he used sky-high interest rates as a controversial way to do it. He reached his goal after two recessions. In early 1971, short-term rates were less than 4%. In October 1979 they had reached 11%, and by 1981 they had skyrocketed to 20%. The Fed was not messing around. Rates were still close to 12% by 1984, and they didn’t fall below 5% until 1991. The 30-year mortgage rate spiked into the high teens in late 1981 and continued at double digits until 1990. The rising rates sent unemployment soaring to nearly 11% in 1981.

But the rate hikes we’re talking about now are nothing like the draconian measures Volcker pursued. Remember, interest rates have been near-zero throughout the pandemic. So, even if the Fed were to raise rates seven times this year to 3.5% or something close to that, as some forecasters now expect, credit would still be cheap by historical standards. The easy-money party has been going on for a long time now, but the Fed is not talking about taking away the punchbowl; they’re simply replacing the sugary punch with something closer to a Diet Coke.

Today’s inflation/rising rates are starkly different than what the U.S. went through in 1982. But can we still learn some lessons from that era?

Stock Market Returns in the 1980s:

Stock market returns were positive despite the double-digit rate hikes, high inflation, and high unemployment. Value stocks did better than growth stocks, and being diversified helped achieve positive portfolio returns.

Here is a chart that shows various interest rates and the S&P 500’s corresponding returns, stretching back to 1970: 

Some key observations:

• Stocks have held up relatively well during past rate-hike cycles.
• The market surged into 1981 but fell 27% in a brutal bear market that extended into 1982 (which included the Fed-induced recession).
• The 1985-1988 period included the biggest one-day crash of all-time in October 1987, a day known as “Black Monday”, when the Dow Jones Industrial Average dropped 22.6%. The market fell a whopping 34% in a week.
• The surprise rate hike in 1994 spooked the bond market as much as the stock market. The S&P 500 quickly dropped 8.5% in the early part of 1994 because of it but came back later in the year as did the aggregate U.S. bond market that had a steep initial drop of 6.4%.

While the bullet points above sound scary, the calendar year returns in the table above show that if investors did not capitulate and stayed invested, the returns were generally positive through the entire period.

The closest economic analogy to the current state of play was the 1960s, though some may point to the inflationary 1970s and 1980s as a more relevant precedent. Either way, the current volatility is nothing close to what we saw in that period; the losses sustained this year suddenly look like a drop in the bucket. To summarize, the stock market did have short corrections and recessions on the way, but it did well overall and recovered after its short bumps.

Bond Market Returns in the 1980s:

Since 1976, the U.S. bond market has had positive returns before inflation nearly every year, with only four exceptions.  The table below also shows what the bond market forward returns were after extreme selloffs. Even in 1994, when the Federal Reserve raised interest rates six times for a total of 2.5 percentage points, bonds lost only 3% in the aggregate. If history is a guide, the current bond market selloff might also be in the last few innings. While periods of rising rates and inflation can be challenging for bond investors, it’s important to remember why you own bonds in the first place; that is, they seek to provide a steady stream of income and may help reduce the effects of stock market volatility on your overall portfolio. Also, bonds have historically declined in value during the early months of a rate-hike cycle. But as interest rates rise, investors can reinvest the proceeds from coupon payments and maturing bonds at higher interest rates, which may improve returns over time.

The Labor Market and the Economy:

As they did in the 1970s, oil prices and inflation have surged in recent months, and economic growth has stalled. Unlike the 1970s, today’s labor market is strong, and despite the first-quarter setback, we still believe the U.S. economy can expand overall for the year. Companies have just published their earnings, and according to Bespoke, companies are tracking 70%+ beat rates for both earnings per share and revenues for the Q2 reporting period, and more companies are raising guidance than lowering guidance.

Market Sentiment:

With headlines like “Nowhere Near Bottom” at the top of the Drudge Report, the pain in financial markets has clearly made its way from Wall Street to Main Street. Probably the most bullish indicator we can find right now is just how bearish everyone is. It’s usually when no one can find anything positive on the horizon that bottoms are made. Historically, when investor sentiment has been this bearish, forward returns going out one month to one year have been very positive.

In the Fed chairman’s press conference, Jerome Powell suggested that history’s test wasn’t whether former Fed Chair Paul Volcker was prepared to tip the economy into a recession to combat 1970s-era inflation, but that the test (then and now) is about doing “the right thing.” As investors, we are facing extraordinary challenges, from geopolitical unrest and shattered supply chains to soaring consumer prices, rising interest rates, and stalled economic growth. While the mix of investor antagonists is unusual, the resulting market volatility is not. Regardless of the backdrop, we encourage clients to remain disciplined and avoid reacting to short-term market swings.

Summary:

This market has already felt a massive amount of pain, as the bubble we saw in the most speculative areas in the early days of COVID has fully burst. The average Nasdaq stock is now 46.5% below its 52-week high, and the average health care stock is off its high by two-thirds. No one knows when it will happen, but one day soon we expect investors to go shopping for “on sale” prices, which will cause a rally that lasts longer than just a few days. In our view, investing across multiple asset classes and sectors and focusing on risk management is a sensible approach, given current market conditions. It’s also important to remember that market unrest often creates investment opportunities. At Bluerock, we have the conviction and discipline to recognize and potentially capitalize on attractive opportunities when they’re significantly undervalued.