The Great Moderation is Over

The Great Moderation, from mid-1980s until 2019 before the Covid-19 pandemic struck, was a remarkable period of stability of both growth and inflation. We were in a demand-driven economy with steadily growing supply. Borrowing binges drove overheating, while collapsing spending drove recessions. Central banks could mitigate both by either raising or cutting rates. That period has ended.

A Regime Shift

The pandemic upended an unusual period of mild volatility in output and inflation.

Volatility of U.S. GDP and CPI, 1965-2022

Sources: BlackRock Investment Institute, U.S. Bureau of Economic Analysis and Labor Department, with data from Haver Analytics, July 2022. Notes: The chart shows the standard deviation of the annualized quarterly change of U.S. GDP and the Consumer Price Index.

We now find:

Production Constraints

First, production constraints – stemming from a massive shift in spending and labor shortages – are hampering the economy and driving inflation.

Record Debt Levels

Second, record debt levels mean small changes in interest rates have an outsized impact on governments, households and companies.

Everything is Political

Third, we find the hyper-politicization of everything amplifies simplistic arguments, making for poorer policy solutions.

Higher Risk Ahead

Policymakers face tougher trade offs in the new regime. Reining inflation comes at much greater cost to growth. Preserving growth comes with much higher inflation. Result: the market demands higher rewards for higher risk.

Sources: Blackrock Investment Institute, July 2022. Notes: The chart shows a stylized depiction of the volatility of U.S. inflation and output during the Great Moderation (1985 2019; green line) and since the Covid 19 shock (2020 to now; orange line). The curves show potential combinations of output (x axis) a nd inflation (y axis) volatility that can be achieved when central banks react to demand and supply shocks hitting the economy. Since the Covid 19 shock, the underlying volatility of dem and and supply shocks has risen, as the orange line shows. This means central banks now face starker trade offs. They can try to rein in inflation, but this comes at a cost of higher outp ut volatility the Fighting inflation outcome on the bottom right. Or they can try to dampen fluctuations in output at a cost of more inflation volatility the Living with inflation outcome on the upper left. For illustrative purposes only.

Bracing for Volatility

This new market environment has echoes of the early 1980s. We are bracing for volatility in this regime. Central banks are rushing to raise rates to contain inflation that’s rooted in production constraints. They are not acknowledging the stark trade-off: crush economic growth or live with inflation.

The Fed, for one, is likely to choke off the restart of economic activity - and only change course when the damage emerges. We see this driving high macro and market volatility, with short economic cycles. Equities would suffer if rate hikes trigger a growth downturn. If policymakers tolerate more inflation, bond prices would fall. Either way, the macro backdrop is no longer conducive for a sustained bull market in both stocks and bonds, we believe. We see higher risk premia across the board and think portfolio allocations will need to become more granular and nimble.

Living with Inflation

We think we will be living with inflation. For all the noise about containing inflation, we see policymakers ultimately living with some of it. We remain overweight equities and underweight government bonds in long-term portfolios. We expect investors to demand more compensation to hold long-term bonds in this new regime. We see a high risk of growth stalling and reduce equities to underweight. We now prefer to take risk in credit because we don’t see contained default risk.

Positioning for Net Zero

We see the bumpy transition to net-zero carbon emissions shaping the new regime – and believe investors should start positioning for net zero. We think investors can be bullish on both fossil fuels and sustainable assets, as we see a key role for commodities in the transition. Yet our work finds that changing societal preferences can give sustainable assets a return advantage for years to come. 

Ready to Shift Views

We stay pro-equities on a strategic horizon but are underweight in the short run. Biases built up during the Great Moderation, like buying risk asset dips, won’t work as well as before, in our view. A new regime of greater macro volatility, shorter cycles and more volatile markets, means a dynamic approach to portfolio positioning. Our conviction is that portfolios will need to change more quickly.

This material is prepared by Wrought Advisors LLC and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Wrought Advisors LLC to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. ©2022 Wrought Advisors LLC