High inflation, tight monetary policy, valuations and returns

Although the Fed is poised to step on the brakes to tackle the highest rate of inflation in four decades, we don’t expect the yields of US equities and Treasuries to rise to anywhere near their peaks in 1982 after the central bank jacked up rates. Admittedly, our projections assume that the returns from these asset classes during the rest of the 2020s will be poor by the standards of the post-GFC era. But unlike in the 1980s, we don’t envisage big bear markets being followed by secular bull ones after inflation is brought back under control. The annual average real returns from US equities and Treasuries in the ten years after (and including) 1982 were ~13.0% and ~9.5%, respectively. Reflecting these stunning outcomes, the equivalent return from a typical 60:40 US equity/Treasury portfolio was ~11.7%, the most in any rolling 10-year annual window in the prior sixty years. The rallies in US equities and Treasuries only began, though, after their yields had soared in the wake of high inflation and the much tighter monetary policy that successfully turned it around. We don’t anticipate a re-run this decade. For a start, we aren’t expecting inflation to stay high for as long, or rise as far, as it did back in the 1970s and early 1980s. By extension, we don’t think the Fed’s response will be as draconian and tip the economy into a recession – the one that ended in 1982 was the deepest since the Great Depression. Instead, we foresee tighter monetary policy being more of a headwind than a hurricane.