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, in our view.
A regime shift
Sources: BlackRock Investment Institute, U.S. Bureau of Economic Analysis and Labor Department, with data from Haver Analytics, March 2022. Notes: The chart shows the standard deviation of the annualised quarterly change of U.S. real GDP and the core Consumer Price Index.
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.
