This ‘higher rates for longer’ saga is more like the 1920-21 depression than the 1970s high inflation era

Welshcake

welshcake@iongroup.com

Sometimes you have to swallow your medicine and take a step back to go forwards

Following a relief rally in credit markets, investors have a window to reappraise the economic downturn and how markets can navigate it in 2023. Further catharsis still looks likely in coming months, but historical precedents give reason to be hopeful about the landscape beyond that point.

For loyal readers of this column, the biggest shock may not be my sudden turn of optimism — you’re probably wondering instead why I’m avoiding mention of Wales’s ‘performance’ in the football World Cup. OK, let’s get this out the way…

In truth, Wales was not a case of high expectation — I can only refer you to what I said when we qualified ahead of Ukraine. Getting to the World Cup was a freak result, like Hans Niemann beating Magnus Carlsen in chess. No aspersions intended, but it felt unfair at the time and we duly got found out. There — happy now?

Our 34-39 loss to Australia in the rugby was far more traumatic, especially after taking a commanding lead. The crisis resulted in Warren Gatland returning as coach, with former Wales centre Jamie Roberts describing it as “a step backwards to take three or four steps forwards”. That’s a message pertinent to financial markets this coming year.

U-turns don’t always convey weakness

Sometimes admitting you’ve gone too far on a path and need to retreat is simply the right thing. Like China with its zero-covid policy, or San Francisco backtracking on plans to unleash killer robots. Everyone in financial markets enters 2023 with high hopes the US Federal Reserve is set to pivot. Of course, the Fed doesn’t want to encourage this. But any consideration of past failures should compel it to change tack sooner rather than later. Rates decisions now could take anything up to six months to be fully felt — heightening the risk of an overshoot that will plunge the economy into depression.

The longer this ‘higher rates for longer’ saga has gone on, the less it looks akin to the high inflation era of the 1970s — and certainly less like the 2008 crisis. Instead it has many hallmarks of the 1920-21 depression.

Consider just some basic elements that got us here: a war, a global pandemic, and — more lately — rising industrial action. These similarities may feel superficial, but the return of soldiers from the First World War, coupled with the prevalence of Spanish flu, caused economies to swing from high inflation to rapid deflation — something that might chime with our re-emergence from lockdown in 2021. As in 1919, economies have not adjusted well to the shifts in supply/demand and the outcome could be a comparable about-face from high growth/inflation straight into sharp recession.

The other unifying theme is monetary policy. Prompted by post-war inflation in 1919, the Fed began hiking its rate, taking it from 4.75% in December to 6% by January 1920, and to 7% by June that year. Economists from Milton Friedman and Anna Schwartz to Paul Krugman have identified this as a major cause of the ensuing depression — and once the Fed abandoned this approach the economy recovered.

This is the risk — and reassurance — investors carry into 2023. There is every chance we are looking at a year of declining growth, lower industrial production, rapidly rising unemployment, and a default cycle we haven’t experienced for some time. But, more optimistically, any sign of the Fed slowing down could be a turning point on which to trade. Credit looks better placed to perform than equity markets in 2023, and far more robust than real assets such as offices and residential property.

But if the historical analogy does play out, there is even more reason to stay chipper. The 1920-21 depression was followed by some eight years of spectacular, ‘roaring’ growth. Given the likely entry levels this shake-out will create, investors could be sitting on the opportunity of a lifetime.

As far as I can tell, only one good thing happened in Wales in 1920, and that was beating England in the rugby — a match in which Jerry Shea produced a historic first on the international stage by scoring a try, conversion, penalty goal and drop goal. To every one of you who’ve read this far, I wish a similar ‘full house’ of success in 2023, and a wonderful break before it begins.

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Global credit funds & CLO's

January 2023 | Issue 251

Published in London & New York.