Russia’s invasion of Ukraine, following hot on the heels of the pandemic, could hasten the transition to a new, more volatile economic environment. That would have major ramifications for financial markets and investors, argues Michael Grady.

Read this article to understand:

  • Why the Great Moderation may be going into reverse
  • The dilemma being posed to policymakers by soaring inflation
  • What the return of economic volatility might mean for financial markets

In 2001, Olivier Blanchard and John Simon were among the first economists to measure and record the sharp decline in US economic volatility since the mid-1980s.1 A year later, Harvard economist James Stock and Mark Watson of Princeton coined the term the ‘Great Moderation’ to describe the phenomenon.2

However, it wasn’t until 2004, when Ben Bernanke – at the time a Federal Reserve (Fed) governor – used it as the title of a speech, that the phrase began to receive more widespread attention.3 In their work, Blanchard and Simon noted the standard deviation of US quarterly real GDP growth fell by a factor of three over the course of the second half of the twentieth century. The more stable economic environment in turn helped explain why US recessions had been getting shorter and less frequent. The trend has appeared to persist since their work was published.

According to the National Bureau of Economic Research, whereas the US economy was in recession nearly 26 per cent of the time from the start of 1946 to the end of 1982, the corresponding figure for the following 39 years was less than 11 per cent.

Figure 1: US recessions become shorter and rarer
Source: National Bureau of Economic Research. Data as of March 24, 2022

In his speech, Bernanke noted economists had advanced various explanations for the Great Moderation, which he reduced to three categories: structural change, improved macroeconomic policy and good luck.

Improvements in computing, which enabled companies to manage inventories far more accurately, increasing sophistication of financial markets, the deregulation of many industries, the transition towards services from manufacturing, and the growth of global trade are examples of structural changes some believe made economies more stable.

There is a widely held view improved macroeconomic policy also played an important role. For example, there is a consensus that monetary policy became more effective after central banks began gaining greater independence around the time the Great Moderation started. By anchoring inflation, they were able to stabilise economic performance. The fact governments generally refrained from using fiscal policy as a tool to control aggregate demand is usually seen to have enhanced the role played by policymakers.

Little more than good luck

However, for others, including Stock and Watson, the Great Moderation was mostly down to good luck. Changes in economies’ structure and improvements in policymaking were less important than the fact exogenous economic shocks had become smaller and more infrequent.

The policy explanation for the Great Moderation deserves more credit than it has received in the literature

As a central banker, Bernanke was unsurprisingly keen to stress the likely importance improved policy had played in taming the economic cycle, even if he conceded structural changes and good luck had played their part too.

“I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature,” he wrote.

Within four years, both Bernanke and other policymakers were being roundly criticised for their hubris, as the financial crisis of 2008 triggered what at the time was the deepest recession since the 1930s. Nonetheless, the spike in volatility was to prove short lived. By July 2019, output volatility had hit a record low as the US economy entered its eleventh year of continuous growth. The longest expansion in history was to continue for another seven months.

Economic volatility returns

The arrival of COVID-19 at the start of 2020 delivered one of the largest economic shocks in history. While the unprecedented actions of central banks and fiscal authorities around the world ensured the recession was relatively short-lived, there are signs the world economy may be entering a far less tranquil period.

The magnitude of the contraction in output caused by the pandemic, along with the equally rapid recovery, has pushed output volatility to a post-war high. At the same time, inflation in much of the developed world has soared to levels not seen in more than 40 years.

Figure 2: Economic volatility returns
Source: Federal Reserve Bank of St Louis, Aviva Investors’ calculations as of March 24, 2022

Even if output volatility seems likely to subside in the coming quarters as the impact of COVID-19 slowly fades, there are valid grounds to believe the pandemic might have marked the end of the Great Moderation. After all, several of the factors said to have played a role in the trend seem to be going into reverse simultaneously.

There are valid grounds to believe the pandemic might have marked the end of the Great Moderation

Take structural change. Numerous supply chains have ruptured because of the pandemic. Although those problems will be fixed eventually, further disruptions look likely. For instance, while the transition to green energy will be positive for the global economy over time, in the short-term it threatens more volatility as countries scrap for scarce resources. Even if this does not necessarily lead to the kind of big swings in inventories cited as the cause of much of the instability seen in the 1960s and 1970s, it could feed inflation for some time.

Meanwhile, rising political tensions across the globe could force governments to pay increasingly close attention to what are deemed strategically important industries, potentially sending deregulation into reverse. And even if talk of the end of globalisation may be overhyped, neither it, nor the liberalisation of capital markets, will provide much of a stabilising force, and could start to work in the opposite direction.

There appears some danger macroeconomic policy, as with structural factors, becomes a force for destabilisation too. Take the conduct of monetary policy. Central banks became progressively more concerned with preventing deflation rather than inflation during the latter part of the Great Moderation. The result was ever more extreme policy responses.

Although the Federal Reserve, for one, is expected to raise interest rates at pace to combat soaring inflation, it has been widely criticised for being slow off the mark. As a result, it arguably needs to tighten policy more aggressively than might have otherwise been the case.

At the same time, both the US and European central banks have softened their inflation targets since the start of the pandemic. Given the asymmetry of those new targets, there are legitimate concerns they may willing to tolerate higher inflation.

Signs COVID-19 may have emboldened fiscal policymakers only adds to the risk. Unlike the period that followed the financial crisis, governments seem in no hurry to reduce deficits. Efforts by some countries to make their societies fairer are likely to stretch finances further.

Fiscal policy could become far less countercyclical than in the years of the Great Moderation

Even if there appears little chance governments will use fiscal measures as a tool to control aggregate demand, as was the case in the 1960s, fiscal policy could become far less countercyclical than in the years of the Great Moderation.

Russia’s invasion of Ukraine, coming hot on the heels of the pandemic, suggests Bernanke’s third explanation, the good luck of the past 30 years, may also be evaporating. Although headline rates of inflation will eventually decline, geopolitical tensions seem less likely to abate in a hurry.

The risk is ongoing disruption to supply chains and further volatility in commodity prices. While it remains to be seen whether this creates the level of volatility that accompanied the energy crisis of the 1970s, it could be the final nail in the coffin of the Great Moderation. If so, that could have major implications for financial markets.

More volatile asset prices?

Since macroeconomic factors such as real interest rates, inflation, unemployment and growth explain a significant portion of equity and bond returns, it makes sense to believe shorter and more volatile economic cycles would likely lead to more volatile asset prices.

The effect of the Great Moderation is perhaps most clearly demonstrated by the fall in the volatility of the US Treasury bond market. In the chart below, this has been proxied by taking the standard deviation of ten-year yields over rolling two-year periods since 1970. While the precise result depends on the starting point, the broad conclusion is the same; volatility has declined.

Figure 3: Declining US Treasury bond volatility
Source: Macrobond, Aviva Investors’ calculations, as of March 24, 2022

Although equity market volatility has also declined over the same period, it has done so by far less, as shown below. Furthermore, this conclusion is highly sensitive to the starting point. Since the mid-1980s, the same measure of volatility has risen slightly.

Figure 4: S&P 500 volatility (standard deviation of monthly returns over rolling two-year periods)
Source: Macrobond, Aviva Investors’ calculations, as of March 24, 2022

This is hardly surprising. Greater uncertainties over future dividend payments, and the difficulty of establishing the correct discount rate to apply, makes shares far harder to value than bonds. That in turn means they are more prone to being driven by sentiment, and to diverge from macroeconomic fundamentals.

The shocks of 2008 and 2020 were insufficient to reset volatility

Nonetheless, the decline in equity market volatility would have been far more pronounced were it not for the extreme sell offs recorded during the financial crisis and latterly the pandemic. Furthermore, that the shocks of 2008 and 2020 were insufficient to reset volatility higher was largely due to the actions of central banks, which were able to adopt a “whatever it takes” mantra because inflation was non-existent. With the world suddenly in a new inflation regime, that mantra will be tested as never before when the next crisis emerges.

One consequence could be unstable bond yield curves, with shorter steepening and flattening cycles. Shorter economic cycles would mean more volatile corporate earnings and greater equity volatility, especially given an unstable discount factor.

Beyond dampening the volatility of individual asset classes, the Great Moderation has been of benefit to investors in another important way, by driving the correlation between stocks and bonds steadily lower. As Figure 5 shows, this has declined inexorably since the middle of the 1980s and, but for a brief interlude in 2007, has been continuously negative for the past two decades.

Figure 5: US equity-bond correlation
Source: Macrobond, Aviva Investors’ calculations, as of March 24, 2022

Shifting stock-bond correlation

According to a November 2002 paper by Yale economist Lingfeng Li, the correlation between stocks and bonds has varied significantly over time. For instance, between 1966 and 2001, it was continuously positive.4 She showed that common exposure to macroeconomic factors drives this correlation, identifying uncertainty about expected inflation as the key factor, followed to a lesser extent by the real interest rate.

However, while a 2007 study by Anderson et al. similarly found inflation was a key factor driving the equity-bond correlation, there is little agreement on what drives this crucial financial relationship.5 For instance, Baele tested for a wide range of factors and found liquidity was important, which he suggested may be linked to a flight-to-safety effect.6

Investors may need to prepare for a very different macroeconomic environment

That there is disagreement is not surprising, since over time different factors can dominate financial markets. Nonetheless, a shift to a more volatile economic regime with higher inflation would threaten to send the trend of the past four decades into reverse. Since both bonds and equities are sensitive to inflation and higher real interest rates, correlations would be expected to rise should these factors become more important in determining asset returns.

While it is too soon to know for sure whether economies are entering a new inflation regime, investors may need to prepare for a very different macroeconomic environment and shift their behaviour accordingly. Low inflation and a negative correlation between bonds and equities can no longer be taken for granted by traditional asset allocators. Those looking to diversify future risks will need to keep a close eye on correlations.

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