Henry Kaufman in 2017.
For some of us of a certain age, an event from four decades ago often is recalled more vividly than what happened four weeks or even four days ago. Such is the case with Aug. 17, 1982. It arguably marked the birth of the great bull market in stocks, which stretched into the next century.
The catalyst came from a dramatic reversal by Henry Kaufman, then the chief economist of Salomon Brothers, perhaps the most powerful bond dealer at a time when interest rates had soared to previously unimaginable levels. Known as Dr. Doom for his influential and prescient forecasts of rising inflation and bond yields during the 1970s, Kaufman’s shift from making doleful predictions set off a bullish stampede.
When Barron’s caught up with him by phone this past week, the nonagenarian sounded as sharp as ever, recalling the markets and policies of the past and contrasting them with those of the present with equal candor.
As for 1982, Kaufman said he made his bullish call after assessing the changes in the economic and market environment during a trip to Europe. Interest rates had peaked the previous October, when long-term U.S. Treasury yields hit 15%. Inflation was abating and credit demand was slowing, while the economy remained in a recession, the second of the back-to-back downturns of the early 1980s.
Inflation remained high, however, and he characterized monetary policy at the time as “relatively tight,” which might strike current observers as understatements. The consumer price index had receded from its double-digit peak to around 7%. Core inflation, which excludes food and energy, was running at 8.5%.
But the Federal Reserve’s policies, which then aimed to control the money supply rather than interest rates, still resulted in a federal-funds rate well into the double digits, although it was in a downtrend from the midteens earlier that spring. Cracks also had begun to appear in the financial system, first with the failure of an obscure government securities dealer in May, then with a Mexican debt crisis in August.
Kaufman’s reversal—which he chronicled in his book The Day the Markets Roared, published last year—touched off dramatic rallies in bonds and stocks, which he attributed to the markets having been accustomed to his previously long-held bearish views. It’s hard to describe how stunning his changed opinion was then, long before the internet or even financial TV channels. It also was a time when the Fed sought to obscure its policy intentions rather than guide the markets.
But the contrasts between then and now are even more fundamental. Real interest rates today are deeply negative, far below the inflation rate, Kaufman observes. That’s whether measured by the 9.1% year-over-year rise in the CPI or, most charitably, the 4.8% increase in the core personal consumption deflator, the Fed’s favored gauge.
Beyond that, the central bank’s approach is starkly different, Kaufman observes. The current monetary authorities prefer to deal incrementally, as opposed to the bold action taken by the Volcker Fed, starting in 1979. In particular, today’s Fed didn’t act swiftly to reduce liquidity by shrinking its balance sheet. Instead, it continued to buy Treasury and agency mortgage-backed securities when inflationary pressures were building last year, notably in the housing market.
“Today, you have a man of much milder behavior who is not an aggressive mover on monetary policy,” Kaufman says, referring to Fed Chairman Jerome Powell.
The character of the policy-setting Federal Open Market Committee also has become less confrontational, with few dissents, he further notes, in contrast to the disagreements seen during the chairmanships of Paul Volcker and his successor, Alan Greenspan. Kaufman also speculates about the influence of Treasury Secretary Janet Yellen, Powell’s predecessor as Fed leader. Trained as a labor economist, she is more predisposed to an easier policy to support jobs than to a tougher one to curb inflation, he says.
All of which leaves the markets in a rather different place than where they were four decades ago. Then, the economy had already gone through the monetary wringer and two recessions to get inflation down below 4%. In contrast, the Fed has only begun to lift interest rates, to just 2.25%-2.50% for its fed-funds target from near zero as recently as this past March, when it was still expanding its balance sheet to inject liquidity.
Even relatively hawkish officials suggest that the policy rate could rise to 4% in 2023, which would put it not far above their end-2023 expectation of 2.6% for the core PCE deflator (with only a minor uptick in unemployment, to 3.9% by then), according to the FOMC’s most recent Summary of Economic Projections.
Kaufman expresses little confidence that the central bank will quickly get back to its previous 2% inflation target. Instead, he suggests, the monetary authorities may equivocate before reaching that goal. In other words, if 1982 was the beginning of the end of the inflation fight, we’re not even at the Churchillian end of the beginning now.
How, then, to explain Treasury bond yields under 3%, with the trailing 12-month CPI over 9%? Kaufman attributes this to feelings that the impacts of high oil prices and the war in Ukraine could resolve themselves.
He also points to the short-term mind-set of institutional investors. They have a trading orientation based on what he calls the illusion of the high degree of marketability of their holdings when they want to sell. That assumption was sorely tested during the pandemic-precipitated upheavals of March 2020. Furthermore, he adds, credit quality has deteriorated during the market cycles of the past decades.
That said, Kaufman says it is clear the U.S. will emerge first from the effects of the pandemic and stands in much better stead than Europe or Asia.
So, what are readers to do with their portfolios? Kaufman demurs, pleading that he lacks acute knowledge when it comes to equities. As for fixed-income investments, he says if you have to buy bonds, he prefers municipals, which offer tax-free yields higher than taxable counterparts, provided you do the requisite credit analysis.
Forty years on, Kaufman may no longer be Dr. Doom, but he still retains his characteristic caution.
Write to Randall W. Forsyth at email@example.com