Shani Jayamanne: Welcome to Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. So, Mark.

Mark Lamonica: Sure, Shani.

Jayamanne: We’ve been doing a little challenge for you to try Aussie classics.

Lamonica: This was imposed upon me.

Jayamanne: Yes

Lamonica: Don't act like I am reluctantly participating. 

Jayamanne:Okay. But you had Weet-Bix yesterday for the first time and …

Lamonica: I did. Are you not going to explain what this challenge – you're just going to give me all these odds…

Jayamanne: Oh, yeah. Sorry. Yeah. I'm going to give you Australian classics, and you're going to rate them out of 10 and see if you try it again...

Lamonica: Yes.

Jayamanne: …or incorporate it into your…

Lamonica: My lifestyle.

Jayamanne: Yeah. So, if anyone has any suggestions on what Mark should try? I mean he's tried all the normal stuff. You've had Tim Tams?

Lamonica: Passion Pop.

Jayamanne: Passion Pop.

Lamonica: You know, just the normal stuff.

Jayamanne: Yeah. So, any …

Lamonica: UDL.

Jayamanne: …suggestions would be good. You've had a UDL?

Lamonica: You told me to.

Jayamanne: Yeah. That's very teenage Western suburbs of you.

Lamonica: Yeah. Well, anyway. Weet-Bix - it was fine.

Jayamanne: And you said you gave it a 6 out of 10.

Lamonica: Yes. There's a lot of discussion about the Weet-Bix. Well, it's like disintegrating in the milk. So, I think maybe if I was more proactive in eating it, it would be better.

Jayamanne: You did say you would – you could probably do four, because I think the quantity of Weet-Bix is very important.

Lamonica: Well, I said that I could do four on like a daily basis, but if this wasn’t sort of competition, I can do a lot more than four.

Jayamanne: Yeah. And the toppings were also a huge consideration. So, I have mine with strawberry jam.

Lamonica: Yes. And somebody stole most of Shani’s strawberry jam...

Jayamanne: I was very upset.

Lamonica: …at the office. Yeah. So, she's now hidden it in the office fridge.

Jayamanne: Yeah.

Lamonica: And I know where it is. So, if the jam thief is listening, let me know and I'll tell you where to find it now.

Jayamanne: Yeah. So, we're going to do Milo next, but if you …

Lamonica: This seems like an easy lift, right?

Jayamanne: Yeah. But if you haven't – there's also like a lot of considerations with Milo, like hot or cold. That's probably about it.

Lamonica: Okay. So, not so much a lot as one consideration.

Jayamanne: Yeah. Yeah.

Lamonica: I want that frozen Milo thing that I bought you once.

Jayamanne: A Scoop Shake?

Lamonica: Yeah. The one that you said reminds you of your childhood. So, I got you one.

Jayamanne: Yeah. I mean, I used to have them in my childhood because we'd stop at like a gas station.

Lamonica: It's called a petrol station in Australia, Shani.

Jayamanne: It was being accommodating to you. And we would stop on road trips and we’d choose the ice cream, and I thought it was like the best value, like it would last the longest.

Lamonica: Well, there you have it. Value for money.

Jayamanne: Yeah. Should we do this episode?

Lamonica: Yeah, we should, because today is exciting because we're going to tell a ghost story, Shani.

Jayamanne: And I think we really like pushing the boundaries on this podcast, Mark. Like should we ask people to listen to this podcast sitting around a campfire? Or …

Lamonica: I mean, if they want, like, the two of us hate camping.

Jayamanne: Yeah.

Lamonica: So, we would not do that. So, I think people should feel free to listen to this wherever they would like.

Jayamanne: Okay. Well, I'm uncomfortable with the notion of telling a ghost story on our podcast. So, what should we do?

Lamonica: Well, we're going to do it anyway, Shani. So, you have to participate in this, because if not, it's just like 30 minutes of Kermit. Right?

Jayamanne: All right. Let's hear it.

Lamonica: Okay. Well, we're going to tell the ghost story of Paul Volcker, who is currently haunting markets. And before we can learn about how he's haunting markets, we should know a little bit about who he is. So, why don't you start us off with who he is, Shani?

Jayamanne: All right. So, Paul Volcker was an American economist who was a Federal Reserve Chairman and served between 1979 and 1987.

Lamonica: And Paul Volcker is widely credited with finally bringing about the end of inflation. And to do that, he drove the U.S. economy into a deep and painful recession. But before we get into that, we need to go back well-before 1979, when he became Chairman of the Fed, and look at the inflationary environment in the '70s.

Jayamanne: Well, in the U.S. and around the world, there was a surge of inflation in the 1970s. Over the entire decade, the average inflation rate was 6.8%, which has doubled the long run historical average and triple the rate of the previous two decades. But even this average inflation number hides the true extent of the inflation crisis.

Lamonica: Yeah. So, in the early '70s, there was an economic boom and a corresponding share market boom, which we've talked about previously with the NIFTY 50 market. But there were several underlying issues in the economy that were building up. But most importantly, there was the shock of the Arab oil embargo in 1973. So, that lasted for five months, and crude oil quadrupled in price and stayed at that level until The Iranian Revolution in 1979, when it jumped again.

Jayamanne: And this oil shock, obviously, was an initial driver of inflation, but there were macroeconomic components to it as well. So, in the late '60s and early '70s, the U.S. government was running a huge budget deficit. This was to fund LBJ’s Great Society agenda and the Vietnam War. This massive budget deficit was combined with accommodative monetary policy, meaning low interest rates, and then increased government spending leading up to Nixon's re-election in 1972.

Lamonica: Okay. Just so I have this straight. There was a surge in share market, there was a lot of government debt and spending, there were increases in commodity prices and there were low interest rates.

Jayamanne: Sound familiar.

Lamonica: Yeah. It's kind of like reading the paper today, right? But anyway, there were lots of other things going on as well, including the wage and price controls and Nixon ending the Gold Standard. In many ways, it was just a turbulent era that represented the end of the post-World War II economic environment, which had a foundation in the Bretton Woods Agreement. But the point of today is not to do a historic review of where inflation came from, the point is to get to what had to be done to end it.

Jayamanne: So, inflation started going up in 1973 and then surged in 1974 to over 11%. And the U.S. economy fell into a recession in late 1973, with unemployment rates starting to go up. The Fed responded to the rise in inflation by starting to increase interest rates, but this, of course, made the recession even worse and unemployment went up to over 9% in early 1975.

Lamonica: And this is where it starts to get interesting. So, there were some initial signs that inflation was moderating, and there was a ton of political pressure on the Fed from Nixon to stop interest rate increases because of the economic fallout.

Jayamanne: It’s almost like Nixon would do anything to get elected.

Lamonica: Yeah. I mean that's strange. Another strange thing going on, right?

Jayamanne: Yeah.

Lamonica: Learning a lot on this podcast.

Jayamanne: Yeah. So, inflation did moderate even with interest rates starting to get cut in 1975. They fell from an annualized rating of 12.34% in December 1974 to 4.86% in December of 1976. But then it started to go up again and by the time Volcker became Fed Chair in August of '79, it was back up to 11.82%, and by the summer of 1980, it reached just under 14.5%.

Lamonica: And many people, including Nixon, when he was putting pressure on the Federal Reserve in the early to mid-'70s, thought there was a trade-off between high inflation and low unemployment. But as inflation persisted, that turned out not to be the case. So, when inflation reached 14.5% in the early 1980s, the unemployment rate was 7.5%.

Jayamanne: This was stagflation, which occurs when you have high inflation, low economic growth, and high unemployment. So, it's a pretty, pretty terrible situation.

Lamonica: It is. It is. So, Volcker takes over a Federal Reserve that had moderately raised interest rates to try and stop the second surge of inflation from a level that was still considered unacceptably high, but it just wasn't working. So, he called a surprise meeting in October 1979 and basically said he was throwing out the Fed's old playbook for how they dealt with inflation. In October, interest rates were at 13.7%. By April of 1980, they were at 17.6%.

Jayamanne: And that is, obviously, a really big increase in a short amount of time, but they didn't stop there. By 1981, they were over 20%. These interest rate rises slowed economic activity and actually put the U.S. into two recessions in early '80s. The first one in January of 1980. So, unemployment take up to close to 8%; and the second one in 1982 saw an unemployment rate of 10.8%.

Lamonica: But this worked. So, inflation went down to 3.4% by the time Volcker left office in 1987. And that ushered in a great era of investing, when interest rates stayed relatively moderate and inflation stayed low. This, of course, was punctuated by the period after the GFC when interest rates stayed very low, tons of liquidity was pumped into the system and we didn't get a whiff of inflation.

And the share market, well, it exploded higher, with returns on the S&P 500, including dividends, averaging an annualized 17.6% between the GFC low in March of 2009 and the end of 2021. And that's just a shocking number.

Jayamanne: That brings us to today and the ghost of Paul Volcker. We are again confronted by inflation, driven by tons of fiscal and monetary stimulus. Again, we had Central Bank as asleep at the wheel as inflation got out of control and they failed to recognize that a lot of the structural changes to the economy and geopolitics during COVID dramatically changed the environment we had all gotten used to. Only time will tell if this is another inflection point like the mid-70s.

Lamonica: And investors clearly don't want this to be an inflection point. And of course, why would they, given those returns since the GFC. But you can't always get what you want, Shani, and the ghost of Paul Volcker may not be hanging over everyday investors, but you can bet that he's hanging over central bankers around the world.

Jayamanne: And Jerome Powell, who sits in Paul Volcker’s seat as the Chairman of the Federal Reserve, spoke on Friday, August 26, and over the past few months, markets have been up as investors envision a short-lived period of interest rate increases. And then a pause before cutting again to rescue a moderately slowed economy. But Jerome Powell seemingly was having none of it. He said that now is not the time to slow interest rate increases and emphasized that price stability was a bedrock of the economy. He said that the Fed would forcefully attack inflation and that some pain would be inflicted on households and businesses.

Lamonica: And the future is, of course, unknowable, but Jerome Powell was clearly no stranger to the inflation struggle during the '70s. So, he was in Uni during the flare up of inflation in 1974 and living and working in New York City in the early '80s. And his counterparts around the world are of a similar generation. So, Philip Lowe was hired into his first job at the RBA in 1980, when inflation was 10.14% in Australia.

Jayamanne: And the Australian experience with inflation was pretty similar and, in some ways, worse. During that initial surge of inflation around 1974, the inflation rate actually went up to 17.5%. And in Australia, inflation was tamed, like in the U.S. At the end of the 1980s inflation in Australia had averaged 9% over two decades. A dollar in 1970 had the purchasing power of $0.17 by 1990.

Lamonica: And many policymakers are haunted by the mistakes made during the last period of inflation and they respect the man who actually ended it. Just like how Munich and the policy of appeasement influenced a generation of foreign policy, I think we're going to be living in the shadow of Volcker during this fight against inflation. So, let's go through some of the lessons that investors can take from this.

Jayamanne: So, the first lesson is that a nightmare scenario for many central bankers is what happened in the 1970s. Lingering inflation, slow growth and higher unemployment. This fear probably equals the fear of deflation that played out during the GFC, where record amounts of liquidity were pumped into the system.

Lamonica: And there is a saying that generals are always fighting the last war. So, I think we all need to be prepared for the consequences of central bankers who continue to aggressively raise interest rates until inflation is truly buried. That maybe longer and higher than many people expect, and that may inflict economic pain. Economies, after all, are large and complex. And they don't turn on a dime.

Jayamanne: So, be prepared for interest rates to go higher than you expect, there seems to be this notion that in Australia, the RBA can't raise interest rates above 3% or so because people can't afford it, be very careful with that assumption. The lesson from the '70s and the late '80s is that in order to truly tame stubborn inflation, you need to inflict economic pain. And that is a very language that is being used by central bankers. That means that economic pain may be inflicted on you through higher mortgage payments and less discretionary spending. For some recent home buyers, that may mean selling houses at a loss because they can't afford them.

Lamonica: That doesn't mean that this is the likely scenario, but it is a plausible scenario. Understand what this scenario would do to your finances. Also, as an investor, understand what this scenario would mean for markets. In the short-term, it would probably be ugly, and we have seen four straight days. We're recording this on the 1st of September – Thursday, the 1st of September. Since that speech by Powell, we've seen four straight days of fairly sizable losses in markets. So, understanding the short-term, yeah, this could get ugly, but in an era of higher interest rates that means that what has been working since the GFC may not work going forward.

Jayamanne: And in a lower return environment, where valuation levels don't get the hit from falling interest rates, it might be back to basics for investors. In this environment, it's important to focus on the little things, minimizing fees and taxes, dividends and financially stable companies with appropriate debt levels and moats that will allow them to pass on higher costs. And this is where we can look at the environment between 1974 and 1982.

During that inflationary time, the S&P 500 returned a price perspective 2.5% a year. Not great, but if you counted dividends and reinvested them, the return was 7.4%. That means that more than 65% of total returns came from dividends. In the post-GFC period until the end of 2021, the dividend contribution to total returns was 13%.

Lamonica: And just remember that as investors, we have to consider all the possible outcomes and get ourselves into a position where giant mistakes don't do more long-term prospects of hitting our goals. We are all going to make mistakes investing. We just need to ensure that we don't make the big ones that are fatal to the future we envision. It's putting all your faith in a return to the post-GFC environment or the way to make money was simply to take on more risk, investing in speculative securities might just be one of those mistakes, as would reacting to a market fall by moving all the cash.

Jayamanne: Just remember that if this is an inflection point, it would represent an incredibly difficult environment to navigate as an investor. We hope that we can provide you with a little bit of guidance to make whatever is happening next a little easier.

Lamonica: Okay. Great. Well, thank you guys very much for listening to a ghost story. That wasn't as bad as you thought, right, Shani?

Jayamanne: No. That was pretty good. Not scary. I mean, a little scary to be honest…

Lamonica: A little scary. Yeah, a little scary, but still good ghost story. Anyway, thank you guys for listening. We would love to see you at our conference. Send me an email. My email is in the episode notes and I'll give you a discounted ticket to the conference and come join us October 13 in Sydney at the ICC or watch from the comfort of your own home as we're going to stream the whole thing. And of course, we'd always love questions and comments and ratings in your podcast app. So, thank you very much.