Financial markets and economic conditions continue to defy conventional wisdom. The global economy refuses to slow down, powered by the re-emergence of large developing nations and a resilient U.S. economy. Inflation is well behaved despite rising commodity prices. Real long-term interest rates seem firmly anchored at about 2 percent. Credit spreads across the spectrum remain tight despite calls for an imminent reversal. Investors flush with cash have high-risk appetites.
Welcome back to the 1960s.
The economic parallels to that decade are striking and deep. Yet somehow, most financial analysts think there's something unprecedented and irrational about the way the world is working now. It's almost as if they skipped economic-history lessons on the go-go '60s. With another growth scare roiling global financial markets over the past few days, this may be as good a time as any to soak in that decade.
If the 1960s is used as the relevant historical template, then a lot of what's going on in this decade makes perfect sense.
The pace and breadth of the global expansion then was similar. With Japan and Germany on the revival path, the forces of globalization and related disinflation were at work. In turn, productivity levels were rising and real interest rates were low. At that time—as is the case now—productivity growth in the United States averaged a solid 3 percent.
High productivity meant record profitability. Just as in recent years, corporate America of the 1960s turned in profits averaging 10 percent of GDP. Strong productivity growth helped companies weather the impact of rising commodity prices. Investors didn't demand high interest rates, as they were confident that inflation would remain well contained due to globalization and technological advances. The U.S. 10-year Treasury bond oscillated around 5 percent for much of the 1960s as well. The business cycle was more muted that decade, allowing businesses to plan with more certainty and take on greater debt.
Global growth and inflation volatility is low today, as it was in the 1960s. The worldwide expansion has been very stable at a high 4 percent over the past four years, while inflation has converged around 5 percent in developing economies.
All this is in stark contrast to the past three decades. In the first half of the 1980s, inflation in developed countries averaged 9 percent. A majority of emerging markets had double-digit inflation in the early 1990s. Little wonder that investors wanted high interest rates.
Many financial analysts haven't lived down those memories.
The phrase "liquidity boom," which is ubiquitous in the financial press these days, seems to suggest that prices are being bid up irrationally as central banks around the world are running very loose monetary policies. These folks cite low interest rates as the single most important data point in favor of their liquidity-boom argument. But if just pumping liquidity into the system could lead to dramatic gains in the economy, then Latin America in the 1980s and Japan in the 1990s would have been growth stories; instead, their central banks let loose the monetary spigots, with no impact on economic growth.
The remarkable feature of the current economic boom is that inflation is fairly quiet even as the global economy is still firing on all cylinders for the fourth year in a row. Inflation and interest rates are being pinned down by productivity gains. The potent combination of strong growth, subdued inflation, rising productivity and reduced earnings volatility is logically resulting in low interest rates and higher-risk appetites. Banks are more willing to lend, and businessmen to borrow, when the overall system is stable. Liquidity is pro-cyclical; it tends to increase and decrease with economic growth.
To be sure, good times don't last forever. After all, the 1960s was followed by a decade of malaise. The obvious question, then, is, how long will the present boom last? The answer: at least until all the cynics buy into the 1960s parallel. The bull market in stocks has been driven mainly by earnings growth, with very little increase in the ratio of stock prices to earnings, reflecting an inherent pessimism in the marketplace.
Bull markets end when investors fully price in the good times, as they did in the late 1960s. However, from 1968 onward, inflation began a structural move higher. Growth started to slow, following more government intervention ranging from increased defense spending to the expansion of the welfare state. As a result, productivity growth and profitability turned for the worse. It's probably too early to worry about such an outcome, with central banks such as the U.S. Federal Reserve virtually declaring victory over inflation. The odds are that we may yet see more exuberance before it all ends, just like in the 1960s.
