If financial markets feel a bit more unsettled to you than usual these days, you’re not wrong. Volatility is elevated in the stock market and unusually high in the bond market. Uncertainty is normal, of course, when it comes to investing, but it does seem that investors have a lot on their plates to digest today. Beginning with high inflation, sharply higher interest rates, and elevated volatility, we can now add a regional banking crisis and a potential recession to the long list of issues that are keeping stock market participants up at night. The question on many investors’ minds is “How did we get here?”
It may seem like a long time ago, but much of what investors are dealing with today can be traced to the onset of the COVID-19 pandemic and the associated government response. The macroeconomic aftershocks of that historic event still reverberate with us three years later. Recall that in one brief 12-month period, from March 2020 to March 2021, the U.S. Congress, in its efforts to battle the pandemic, passed three separate emergency spending packages totaling more than $5 trillion, an amount equivalent to nearly 25% of US GDP. (By a quirk of fiscal timing, this shows up as two separate annual deficits of 15% and 10% in the chart below). In the past century of economic data, that level of spending has not been seen outside of a major world war. In other words, relative to GDP, the COVID-19 response approached the scale of the cost of fighting World War II in 1942, 1943, or 1944.
It is, therefore, unsurprising that we would experience some market distortions as this deluge of government spending worked its way through the economy, as it did in post-war America. Four of the most analogous consequences to that period are:
- much higher levels of public debt;
- rapid economic growth (experienced from 3Q2020 to 4Q2021);
- higher inflation;
- higher interest rates.
Higher interest rates (4) led to historic losses on fixed income investments in 2022, particularly for longer-duration bonds. These lagged effects are having a notable impact today; in the past month, Silicon Valley Bank and a handful of others required a government rescue and expanded FDIC coverage due, in large part, to a sudden loss of confidence by depositors, which was sparked by the realization of significant fixed income losses on the banks’ balance sheets.
History never repeats exactly; yet, given the many parallels to the post-WWII era, it’s interesting to examine the economic and market environment experienced by investors in the late 1940s and early 1950s, who faced a similar period of extreme fiscal and monetary stimulus and very high levels of accumulated public debt. First, as wartime production ramped up, the economy boomed from 1941-1945, reaching peak levels of real GDP growth in 1942 of +18.9%, followed by +17% growth in 1943. Inflation rose, as well, but remained relatively subdued (below 10%) throughout the war, only reaching double digits after the war’s conclusion in 1946 and 1947. A recession ensued following the end of wartime spending in 1946, but GDP growth rebounded by the end of 1947 and averaged nearly 5% annually from 1948-1953.
Fascinatingly, interest rates did not rise during this period. Concerned about the interest expense on the accumulated wartime debt, the Federal Reserve and the U.S. Treasury worked in tandem to peg short-term interest rates at 0.375% on T-bills and capped long-term interest rates on Treasury bonds at 2.5%. This required a significant expansion of the Federal Reserve’s balance sheet in order to purchase an amount of government debt sufficient to control interest rates. This policy (called “Yield Curve Control”) eventually ended with the Treasury-Federal Reserve Accord of 1951.
And, finally, the stock market performed strongly throughout this period, returning +15.4% annualized between 1942 and 1952 and experienced only one negative year (1946). Bonds, however, produced deeply negative real (inflation-adjusted) returns over this time frame (due in large part to artificially suppressed interest rates). In other words, stocks worked much better than bonds to preserve wealth during the high inflation of the late 1940s. This article is a reminder that public corporations can adapt even to extreme economic environments and continue striving to maintain profit margins and generate positive earnings for shareholders.