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The Great Moderation which was active for 30 years is over. Volatility is back.

01:00 PM 07/15/2022
BlackRock issued 2022 MIDYEAR GLOBAL OUTLOOK called “Back to a volatile future”. Here they make a brave claim that the Great Moderation is over. It was active ~35 years so this call implies long term change in the market regime. If correct this is good for novices who will get an advantage as the value of experience of experienced investors will quickly decrease.

What is the Great Moderation? Let’s go to the description in the Jeremy Siegel book Stocks for the Long Run (5th edition):

The economic backdrop for the financial crisis of 2008 was the “Great Moderation,” the name that economists gave to the remarkably long and stable economic period that preceded the Great Recession. The volatility of key economic variables, such as the quarterly changes in real and nominal GDP, fell by about one-half during the 1983–2005 period compared with the average levels that existed since World War II. Although part of this stability was ascribed to the increase in the size of the service sector and advances in inventory control that moderated the “inventory cycle,” many attributed the reduction of economic volatility to the increasing effectiveness of monetary policy, primarily as practiced during the tenure of Alan Greenspan as Fed chairman from 1986 through 2006.

As one might expect, risk premiums on many financial instruments declined markedly during the Great Moderation as investors believed that prompt central bank action would counteract any severe shock to the economy. Indeed, the 2001 recession reinforced the market’s opinion that the economy was more stable. That recession was very mild by historical standards despite the popping of the huge tech bubble in 2000 and the consumer retrenchment that followed the 9/11 terrorist attacks.

Another good explanation can be found in Bernanke’s speech on February 20, 2004:

“One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John Simon (2001) documented that the variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds. Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation "the Great Moderation." Similar declines in the volatility of output and inflation occurred at about the same time in other major industrial countries, with the recent exception of Japan, a country that has faced a distinctive set of economic problems in the past decade.”

BalckRock’s paper argues this period has ended. This was a demand-driven economy with
  1. Supply growing steadily
  2. Rise and falls in borrowing defined demand, and borrowing was regulated by central banks
Now, when supply is no longer stable, monetary policy is not enough to moderate economic cycles. And (adding from outside) governments forgot how to use government investments. We have seen clumsy attempt to increase government spending by giving money for free, without any incentive mechanisms mostly in Developed Markets (DM) during COVID-19.

Returning to BlackRock, they think the Great Moderation is over due to the following factors:
  1. Production constraints. And they will stay due to political fragmentation and attempts to transition to Net Zero.
  2. High debt levels – for the last 30 years low volatility increased debt levels
  3. “Hyper-politicization of everything amplifies simplistic arguments, making for poorer policy solutions”
We are entering a period of high volatility.

The paper confirms a logical view that the current inflation is not linked with demand and rate hikes are not an efficient way to stop it. The Fed will keep fighting inflation and avoiding thinking about the economic growth as inflation became a political target. The data used by Fed is not enough to stop it in time.

As a result, when the Great Moderation is over, the signal from the central banks will be less useful. This is good news – investors will focus more on fundamental data and less on following each word from the Fed.

Outcomes for investors:
  • Volatility is back.
  • Inflation is back. Using only monetary policy and without flexible investment and supply policy Fed + Government will not be able to manage inflation any longer
As a result:
  • The risk premium will increase for all assets. This is also good news – investors will become again compensated for taking the risk.
  • Old patterns will not work (beware algo traders)
  • Fundamental views on sectors and below will help
  • Strategies will change more quickly. Probably strategists should change from Annual to Quarterly or event-driven complete updates of investment strategies.
Asset allocation:
  • Underweight DM Equities except Japan as they don’t incorporate the risk of Fed tightening too much and earnings not meeting current estimates
    • Buy Equities when Fed shows a dovish pivot
  • Overweight credit as fixed income yields are high enough to compensate for the risk
After reading all these the idea is that it looks very difficult. Can we again go to the nice times and reconstruct the Great Moderation? BlackRock sites Academics Jim Stock and Mark Watson who coined the term Great Moderation in 2002. They think it was mostly luck.

Bernanke in his speech mentioned above says that luck is one of the three possible explanations of why the Great Moderation happened: “occurred because the shocks hitting the economy became smaller and more infrequent”. So, it’s worth to assume that COVID-19 lockdowns and subsequent money printing (loose monetary policy) were too big shocks for the Great Moderation to survive.

But who knows? With the current availability of data and after remembering the idea that the government can also invest and not only print money the policy markers with the help of macroeconomists will invent some new set of Tools and create “the Great Moderation v2”. We are positive that it can happen but probably not soon, at least 10+ years are needed.

Tags: GDP growth, Inflation, Volatility