Discomfort and risk are only acceptable in the case of the potential for greater reward. This statement is true in many walks of life, such as in challenging or dangerous jobs that demand higher salaries.
This principle applies acutely to investments. The more volatile an investment is, the higher the return investors expect from the investment. This happens through the mechanism of lower average prices, meaning lower valuations in equities and higher yields in interest-bearing investments. This qualitatively stands to reason, and its self-evidence translates to quantitative financial engineering as well, in which the direct correlation between volatility and risk premium is encoded into pricing models. On much of Wall Street, volatility and risk are interchangeable, as value-at-risk models rely heavily on volatility data to measure risk under different macro scenarios.
So, what happens when the volatility of the entire economy looks set to increase?
At issue is the potential end of the Great Moderation. In former Federal Reserve Vice Chair Alan Blinder’s A Monetary and Fiscal History of the United States, 1961-2021, the Great Moderation is described as “the sharp reduction in the volatility of real GDP growth from quarter to quarter or year to year that began around 1984.” Blinder also points out that inflation was low and stable for most of that period. Simply put, economic results became much less volatile in the thirty-five years following 1984. Blinder’s chart below is a useful illustration:
The reasons for the Great Moderation seem to be relatively simple. For one, advancements in the conduct of monetary stabilization, aided by rapid progress in data quality and collection as well as new mechanisms like forward guidance, gave monetary authorities a greater sense of awareness of boom-and-bust cycles. This knowledge helped Greenspan’s Fed, for example, deliver a textbook soft landing in the mid-1990s as a potentially overheating economic recovery was dampened by interest rate increases. It also helped Bernanke’s Fed take the scale of emergency action needed to help arrest the Great Financial Crisis. Low inflation was also key, as seemingly structural low and stable prices give central bankers more flexibility to pursue a variety of policies to stabilize economic growth. It is, after all, easier to pursue policies to achieve the “full employment” part of the dual mandate when the “stable prices” side seems to be taking care of itself.
The Great Moderation period was marked, importantly, by good luck on the supply side. Supply shocks like the OPEC shocks in the 1970s that jolted energy prices higher were avoided. China joined the world economy in the 1990s and 2000s, and they along with other developing Asian economies offered developed economy corporations cheaper labor (and subsequently, for developed economy consumers, cheaper goods). The end of the Cold War and the security guarantee of American unipolarity encouraged the development of expansive, complex, and efficient supply chains, further reducing costs. These developments came to pass as productivity entered a secular ascent in developed economies driven by exponential advancements in computing. Cheap capital inspired many companies seeking market share in new innovative industries to “race to the bottom” on prices to grow their customer base at any cost. A structural slack appeared evident in the U.S. labor market, with excess workers taking jobs driving for ride-hailing apps or generating freelance graphic designs to tuck some of the technological productivity gains into their own pockets.
But over the past three years, a stochastic shock – a once-in-a-generation pandemic – set off a supply shock, in both goods and the labor market, which fused with expansive and seemingly excessive fiscal and monetary demand stimulation to wake up the dormant forces of inflation. Interest rates have jumped off their near-zero lows. Capital is no longer so cheap; growth at any cost is not a viable corporate strategy. Taken together with fraying geopolitics between the world’s two largest economies (not to mention the total breakdown between the Western world and Russia), and clearly many of the supply forces that drove lower prices are now working in reverse.
If the standard deviation of the real GDP growth rate is set to return closer to its 1949-1983 average of 4.5% from its 1984 to 2019 average of 0.8% (numbers according to Blinder’s analysis), investors should return to the principle that higher volatility means structurally lower prices. How much lower? That is less useful to speculate on than to recognize that prices may instead face a ceiling as long as the situation persists. In the long run, bond and stock prices do depend on economic results to drive their fundamentals. Higher economic volatility could mean more lasting and regular adjustments to term premia across the yield curve, precluding sustained bond rallies, and to enduringly low stock market valuations to account for greater earnings volatility.
Lower average prices at the hand of higher economic volatility should, however, mean greater opportunity for investors who seek to tactically profit from stock and bond market volatility. In Axiom’s view, if the market is indeed exiting this prolonged period of low economic volatility, investors should seek alternative strategies and steer clear from passive indexing related strategies.