Don’t overlook the market lessons of the 1940s

When the US Fed also pursued an aggressive monetary policy by lowering interest rates and using QE


While many economists have tried to compare the current macroeconomic landscape to the roaring ’20s (optimistic scenario) or the ’70s (pessimistic scenario), the context of the ’40s is also rich in lessons, writes Charles-Henry Monchau, CIO at Bank Syz.

“We are at war.” This much-criticised sentence pronounced by French president Emmanuel Macron during his health crisis speech in March 2020 is still in our memories. Armed conflict has resulted in far more victims than the current pandemic, but also in enormous material damages that required a major reconstruction effort.

Yet some experts make comparisons between the current macroeconomic situation and that of the ’40s.

During these two periods financial markets faced uncertainty and spikes in volatility. The source of this disturbance: the Second World War 80 years ago and the Covid-19 pandemic today.

Although these two crises are structurally different, they have the following similarities.

Government debt

The ’40s is the only period in modern history when government officials increased spending in the same way as in the current health crisis – massively and on purpose.

We cannot compare either the ’20s or the ’70s to this exceptional situation. In the ’20s, the budget was at equilibrium, debt was under control and the Fed had raised interest rates.

Governments around the world did not adopt Keynesian policies until the ’30s.

During the crisis of the ’70s, the budget deficit remained below 1% of GDP until 1974. It was only after ’83 that the latter exceeded the 4% threshold for a prolonged period.

Let us look back to the ’40s. The Second World War proved very costly, leading to rising deficits and debt. In 1940, the US budget deficit was 3% of GDP before dropping to -13.9% in 1942 and -29.3% in 1943.

The Covid-19 crisis has also led to substantial deficits and heavy debt. In 2020, the budget deficit reached about $3.1trn (£2.3trn) – 15% of GDP – compared with $984bn in 2019. The national debt rose from about $22trn in 2019 to more than $29trn today.

Central bank intervention

In both periods, the US Federal Reserve pursued an aggressive monetary policy by lowering interest rates and using quantitative easing to stimulate the economic rebound and support financial markets.

During the Second World War, the Fed did not hesitate to use unorthodox methods such as yield curve control by buying US Treasuries. This policy aimed to reduce the interest burden the US government faced with an explosion of debt and budget deficits.

During the 2020 pandemic, the Fed and other central banks also resorted to an asset purchase programme consisting of the purchases of Treasuries and mortgage- backed securities.

Demand and supply shock

Another similarity between the two periods is the sharp increase in demand for durable goods and the shortages observed at the end of the crises.

Similarly to the present, the restrictions in place during the Second World War resulted in high levels of excess household savings. The US household savings rate reached 27% of annual income, four times the pre-war level.

On the supply side, many assembly lines were severely disrupted as the US government asked factories to focus on producing military equipment.

This resulted in shortages of durable goods, a situation exacerbated by the strong recovery in demand once the war ended. This dual shock – rising demand and supply bottlenecks – caused a series of inflationary spikes during the ’40s.

A similar scenario unfolded in 2020-21. The demand recovery is turning out to be much stronger than expected as the world faces shortages of labour, goods and services, transportation delays, and supply-demand imbalances in the energy sector.

Much like in the ’40s, we are now facing a rise in inflation far higher than expected.

Negative real interest rates

As discussed above, the fiscal stimulus has had a very positive impact on growth, while the double shock of rising demand and restricted supply led to a sharp rise in inflation.

Under normal circumstances, such a surge in inflation would have put significant pressure on bond yields. However, under pressure from the US Treasury, the Federal Reserve capped longterm government bond yields at 2.5% until spring ’51.

As a result, real interest rates became very negative in the ’40s, allowing the government to deleverage and the financial markets to stabilise.

These negative real rates also encouraged the purchase of risky assets such as equities and lower-quality bonds, as investors had no other choice if they wanted to earn a positive real return.

History often rhymes

The current macroeconomic scenario seems to have some similarities with that of the 40s: high growth, high inflation, record debt, abnormally low interest rates, and so on. However, there are some notable differences.

We believe global economic growth should normalise in the coming years. The same is true for inflation.

First, the dual demand-supply shock should start to unwind next year. Second, there are now secular deflationary trends that we call the three Ds – demographics, digitalisation and debt.

Only the last factor – debt – was relevant in the ’40s. Inflation could therefore be close to peaking, although it could remain above the Fed’s target for a longer period than initially expected.

On the other hand, it is unlikely the huge debt and large budget deficits in the US can be eliminated in the coming years. As a result, interest rates and nominal bond yields may remain low for a few years to allow the US Treasury to meet its borrowing obligations.

Inflation above the central bank’s target and an expansionary monetary policy should de facto generate negative real rates, which is rather favourable for risky assets. Beware, however: this exceptional situation could lead to volatility in macroeconomic figures – with a corresponding increase in financial market volatility.

This article appeared in the January edition of Portfolio Adviser magazine.

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