In response to the coronavirus pandemic, the U.S. government embarked on an unprecedented surge of fiscal spending and monetary easing that has continued unabated ever since. One year later, as the economy is starting to open up, inflation pressures are rising, although it is still unclear whether these pressures will be transitory or not.
While finding appropriate historical analogies is always tricky, the current economic environment seems most reminiscent of the mid-1960s. Those years represented an inflection point, much like today, when fiscal spending accelerated. The Federal Reserve financed that spending with low-interest rates, assuming that historically low inflation levels experienced in the early 1960s would continue. To be sure, inflation worsened considerably in the 1970s, but the foundation for accelerating inflation was built during the mid-to-late 1960s.
Upon his swearing-in, President Lyndon Johnson pursued an agenda that included an ambitious level of fiscal spending, following a significant tax cut that was passed in 1964. U.S. commitments in fighting the Vietnam War escalated even while domestic spending increased under the auspices of various Great Society programs that were intended to reduce minority unemployment and income inequality. Economists often refer to the era of the late 1960s as the “Guns and Butter” era, as that administration chose to pursue several ambitious goals at once, all of which required significant and sustained increases in fiscal spending along with an expanding budget deficit. The average year-over-year growth rate of government spending increased from 5.5% per annum from 1960 through 1964 to 10.8% per annum from 1965 through 1969 (see chart below).
Reminiscent of President Johnson’s 1964 tax cuts, President Trump signed a large tax cut in 2017, even while the economy was growing at a reasonable rate and unemployment was low. President Trump also oversaw the most significant fiscal expansion in U.S. history in 2020. The Federal deficit reached an estimated $4 trillion, representing a year-over-year increase in government spending of 43%. With a new administration in place, President Biden has communicated his intention to pursue multiple sweeping goals simultaneously. These goals include but are not limited to providing support for individuals and groups who have been economically harmed by the pandemic, combating climate change, making infrastructure investments, and providing Social Security and Medicare benefits to a growing population of retirees. Given the Biden administration’s plans, it is not unreasonable to assume that the budget deficit could remain around $3-4 trillion per year between 2021 and 2025, representing a fiscal expansion similar in magnitude to the one undertaken in the late 1960s.
Early on in the Johnson administration, President Johnson met the Federal Reserve Chairman at the time, William McChesney Martin, and famously tried to intimidate him into keeping interest rates low and monetary policy accommodative. After the Federal Reserve raised interest rates in 1965, Johnson said to the Chairman, “Martin, my boys are dying in Vietnam, and you won’t print the money I need.” Although Martin was a strong proponent of an independent Federal Reserve and an anti-inflation hawk early in his career, he complied with President Johnson’s demands. Ultimately, Chairman Martin decided to provide monetary accommodation to fund the U.S. government’s spending plans, despite the inflation risk. The average year-over-year growth rate in the monetary base, which was 1.8% between 1960 and 1964, tripled to 6.0% between 1965 and 1969 (see chart below). Chairman Martin confessed his regret in acquiescing to President Johnson’s demands years later, saying, “to my everlasting shame, I finally gave in to him.” He stepped down from his position in 1970, but only after he had let the inflation genie out of the bottle.
Similar to what occurred in the 1960s, the current Federal Reserve’s independence has weakened considerably during the past year due to the current war on the coronavirus and the need to finance multi-trillion dollar annual fiscal deficits. The choice of former Federal Reserve Chair Janet Yellen as Treasury Secretary is somewhat symbolic of the marriage that seems to have occurred between the Federal Reserve and the U.S. Treasury Department. Relatedly, the Federal Reserve is determined to protect the nominal value of financial assets and especially the value of U.S. Treasuries. Not doing so would likely have catastrophic consequences on the housing market, the stock market, and U.S. tax receipts, all of which are increasingly reliant on low-interest rates. Even while the Consumer Price Index is likely to exceed 3% during Q2 2021 for the first time in years, current Federal Reserve Chairman Jerome Powell has communicated his view that the current inflationary pressures are transitory, assuming, like Chairman Martin, that inflation remains well-contained. While Chairman Powell may well turn out to be correct, four trillion dollars a year in fiscal deficit spending facilitated by a 0% Federal Funds rate and a skyrocketing money supply is likely to be a recipe for inflationary acceleration.
The spending during the Guns and Butter era created inevitable inflationary pressures that continued through the 1960s. During the early 1960s, inflation was well-contained, with the Consumer Price Index fluctuating in a relatively tight range of 1.1% to 1.6%. With increasing fiscal commitments and money supply in the late 1960s, however, inflation accelerated. In 1966, the Consumer Price Index increased by 3.0%, and by 1969, the Consumer Price Index increased by as much as 5.8%. Similarly, in the past five years, inflation has been low and contained, comparable to the inflation rate of the early 1960s. The average year-over-year increase in the Consumer Price Index was just 1.8% from 2016 through 2020. Looking forward over the next several years, it would be unsurprising to see a CPI acceleration that rhymes with the late 1960s.
Important similarities exist between the late 1960s and the current era, but there are also important differences. The dollar is no longer pegged to the gold price, and the trade deficit has expanded significantly. Because U.S. government debt is currently so large relative to GDP, the Federal Reserve’s options are limited by the necessity of keeping debt service costs reasonable, regardless of the Fed’s inflation outlook. China has developed into a geopolitical and economic foe of the United States, and cheap imports from China have had a deflationary impact on the United States over the past twenty years. Finally, while the Biden administration is planning enormous fiscal spending initiatives, significant income tax increases would dampen their inflationary impact. Put more simply, many similarities seem to exist between the current era and the mid-1960s, but the situation is complex and dynamic with many moving parts.
The 1970s are well known for being a period when inflation accelerated further even compared to the late 1960s. At some point, it may well be worth comparing the 1970s to the current era. Before inflation reaches the 10% inflation rates of the 1970s, however, it must first reach the 5% inflation rates of the late 1960s, and for this reason, the 1960s seem to offer a more applicable comparison for the next couple of years.
Having discussed the macroeconomic backdrop of the 1960s, let us now examine what happened to the primary asset classes during the five years beginning on January 1, 1965:
- Stocks: Adjusted for inflation, the S&P 500 Index generated a total return of 0.3% per year. Earnings increased by 0.6% per year adjusted for inflation. However, as is often the case when inflation increases, the P/E ratio of the S&P 500 Index contracted, from 18.8x to 15.8x, and the dividend yield increased from 2.9% to 3.5% between the beginning of 1965 and the beginning of 1970. Today, the S&P 500 Index is currently trading with a P/E ratio of 33.7x and a dividend yield of 1.5%. The P/E ratio is extremely high compared to history, and the dividend yield is extremely low compared to history. Unfortunately, increasing inflation generally results in a contraction of P/E ratios and an expanding dividend yield. Accelerating inflation today could result in a significant downward re-rating of P/E ratios, which might make it difficult for the stock market to keep up with inflation.
- Bonds: In 1965, the yield to maturity on 10-year Treasury bonds was 4.2%; by the time the decade ended, the yield-to-maturity on that same bond, with five years remaining until maturity, was 8.2%. The total return of that 10-year Treasury bond was an estimated -33.1%, or -7.7% per annum, adjusted for inflation. Bonds woefully underperformed other asset classes during the late 1960s, as one might expect in any environment where bond yields are rising to compensate investors for increasing inflation expectations. The yield-to-maturity on 10-year Treasury bonds is currently 1.7%, which means that the downside risk of a rise in bond yields is greater today than it was in 1965. For this reason and others, it probably makes sense to seek out substitutes for bonds in your investment portfolio.
- Home prices: Housing performed better than bonds in the late 1960s but still did not keep up with inflation. Home prices increased by 3.3% per year, but home prices declined by a slight -0.6% per year adjusted for inflation. Houses tend to keep up with inflation due to increases in wages, land costs, and construction costs, all of which occurred during the late 1960s. In recent months, land prices, construction costs, and wages are rising, all of which support rising home prices. It seems likely that home prices should approximately keep pace with inflation, as they did in the late 1960s.
- Gold: During the Johnson administration, the dollar was pegged to gold at $35/ounce, and it was not yet legal for Americans to own physical gold during that period. However, demand for gold among Europeans increased significantly; during the 1960s, U.S. gold reserves dropped by 38%, from 15,800 tonnes to 9,800 tonnes as undervalued U.S. gold flowed to Europe. After the dollar/gold peg was removed in 1971, gold’s return was spectacular during the following decade as investors sought to sell dollars to invest in gold as a store of value. While not an investment option in the late 1960s, it’s probably a good time to own gold, which will likely serve as an excellent long-term store of value should inflation continue to increase.
Looking back at how these asset classes performed in the late 1960s, the results seemed to coincide with the era’s inflationary circumstances. Housing and stocks were the relative winners, generating returns that kept up with, but did not exceed, inflation. The clear loser of the late 1960s Guns and Butter era was the bond market, which suffered from increasing bond yields and gradual erosion of purchasing power. It probably makes sense to be wary of bonds today and to seek out reasonable bond substitutes. It also makes sense to own reasonably priced stores of value, such as gold.
Disclosure: This article is for informational purposes only and is not a recommendation of a particular strategy. The views are those of Adam Strauss as of the date of publication and are subject to change and to the disclaimer of Pekin Hardy Strauss Wealth Management.
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