By Justin Thomson – Chief Investment Officer, International Equity, T Rowe Price
Economist Paul Samuelson once said, “When the facts change, I change my mind. How are you?”
Many economic facts have changed in recent quarters. In fact, everything I’m observing tells me that we’re going through a paradigm shift in investing. We are moving from a world of mild disinflation to a world of higher trend inflation. From an environment of very low interest rates to an environment of rising interest rates. From a long period of low volatility to a period when volatility is likely to be elevated. From globalization to de-globalization, or friendshoring, as former Federal Reserve (Fed) Chair Janet Yellen calls it. From maximum liquidity to liquidity withdrawal. And perhaps most importantly, from an era of high valuations in both equities and interest rates to one closer to the historical norm (Exhibit 1).
Out with the old, in with the new
(Fig. 1) The paradigm shift in investing
As of August 31, 2022. Source: T. Rowe Price.
How can investors react to this?
Learn the lessons of history
To understand the present, it sometimes helps to study the past. In the mid-1960s inflation began to rise again after a long period of generally low inflation. It continued to rise in the 1970s and early 1980s – a period that came to be known as the Great Inflation – and included four recessions, two severe energy crises, a prolonged period of stagflation and unprecedented levels of wage and price controls in the United States peacetime.
The Great Inflation lasted until 1982, but the seeds for its reversal were sown four years earlier, when Arthur Burns’ tenure as Fed Chairman ended. During his eight-year tenure, Burns showed little inclination to tackle inflation and was widely regarded as a political pawn. At the behest of President Nixon, Burns cut interest rates just when they should have been raising, fueling a US economic boom ahead of the 1972 election.
Burns was replaced by George William Miller in 1978, but it was Paul Volcker, who took over as Fed chairman in 1979, that really brought about the end of the Great Inflation. Volcker, understanding that the central bank had a crucial role to play in fighting inflation, immediately raised interest rates. This led to the painful recession of 1980-1982, sparking widespread protests and political attacks, but also ushering in a new era of disinflation.
Today there are some parallels. The current phase of inflation, like that of half a century ago, began after a long period of low inflation. And shocks in global energy and food prices exacerbated the problem in the 1970s, as they are now. So, are we on the verge of another major inflation?
I do not think so. Despite similarities between the present and the 1970s-early 1980s, there are also significant differences. In the 1970s, the Fed was under intense pressure to avoid anti-inflationary policies that would slow growth; Today, current Fed Chair Jerome Powell enjoys considerable support from the White House and Congress in his efforts to bring down inflation.
The fact that most of the leading central banks are now independent, meaning they are able to make policy decisions based on economic data rather than short-term political interests, also puts us in a much better position to control inflation to control than we were in the 1970s and early 1980s. I think it will stay that way. It would be foolish to lose the credibility that inflation has won over decades.
A new era of financial markets
However, there is a downside. While independent, inflation-oriented central banks are good for the economy, they’re not necessarily good for financial markets — at least in the short term. Over the past 14 years, central banks have deliberately attempted to keep asset prices high as part of their stimulus packages. That is no longer the case. For now, at least, it appears that central banks are less concerned with your stock portfolio and more concerned with “driving down” asset prices to tighten financial conditions while keeping financial markets functioning.
This is the paradigm shift I was referring to, and it could have long-lasting effects. Under the old paradigm, it was possible to achieve success by identifying the best assets in each sector and watching them rise in value. This probably won’t work in the new era. Gone are the days of high valuations fueled by central bank generosity. In the new era, investors will likely need to be more valuation sensitive than they have been in recent times. Traditional skills such as identifying stock drivers and idiosyncratic risk will of course continue to be essential, but more sophisticated and holistic investment frameworks may be required to consider broader macroeconomic, social and geopolitical factors along with company fundamentals.
Investing in a new era
(Fig. 2) Four interdependent dimensions of successful investing
As of August 31, 2022. Source: T. Rowe Price.
Doing nothing is not a strategy. As well-known investor Martin Zweig famously said, “It’s okay to be wrong – it’s unforgivable to be wrong.” best develop new reality.
In practice, this means thinking about the opportunity cost of each position held. It means listening to the views of others—especially those whose opinions don’t align with your own. It means only taking risks that truly match the depth of your beliefs to avoid unexpected risks undermining your portfolio. It means staying active because volatility is your friend.
We’re probably in the very early stages of a negative earnings revision cycle, so it’s important for investors to test models and understand where earnings are most vulnerable. How will higher inflation and interest rates affect the businesses you own? Do they rely on a steady stream of cheap financing or are they overly dependent on stock options to attract talent? Are their operational and financial leverages healthy?
Market dynamics have changed — likely permanently — but that doesn’t mean alpha isn’t on offer. I believe that investors who are active and adapt to the new paradigm have a good chance of emerging stronger from this difficult time.