End of the Great Moderation creates jitters and alpha opportunities

November 16, 2022

After decades of low inflation and low interest rates, the era of the Great Moderation is over. David Riley explores the new fragilities emerging, alpha opportunities and what to expect in this new world of greater macro uncertainty and market volatility.

I was recently asked whether Covid-19 and the war in Ukraine have created a bigger economic shock than the financial crisis that sank Lehman Brothers and saw several European countries bailed out.

My answer was that this time it’s very different. Last time there was a banking crisis that turned into a major economic shock, but it did not fundamentally alter the era of the Great Moderation that had started in the 1980s. Globalisation had brought us three decades of low macroeconomic volatility, low inflation and low interest rates.

Central banks kept policy supportive for markets and cranked up the money-printing presses during more turbulent times that suppressed it.

That era is over. Covid-19 was the final nail in the coffin of the Great Moderation era. For investors, this signalled the return of inflation and higher rates for longer, more macro volatility, and crucially the end of the central bank ‘put’ for markets that suppressed volatility and risk premiums across assets.

The bad news is that the transition to a new investment regime is characterised by a breakdown in the negative correlation between equities and bonds and large drawdowns faced by investors. The good news is that there are opportunities in this new world for generating alpha by taking an active and unconstrained investment approach.

The end of the Great Moderation

Covid-19 accelerated the trend of deglobalisation by exposing vulnerabilities in global supply chains and prompting governments to encourage the production of goods within national borders or ‘re-shoring’.

This, combined with demographic shifts, is making labour more expensive, pushing up costs and prices, and forcing central banks to raise interest rates.

To help anchor inflation expectations, central banks are focusing on their inflation-fighting mandates and stopping large-scale asset purchases – reducing their support for the markets and for investors.

The UK mini-budget was the first casualty of this regime change. A strategy of unfunded tax cuts and fiscal stimulus three or four years ago when inflation was low, interest rates were close to zero and the Bank of England was buying government bonds would not have spooked the markets in such an extreme way. Within central banks unable and unwilling to support profligate borrowers, including governments, the UK was punished for unsustainable and incoherent policy mix.

Where are the new fragilities?

As this shift happens, it’s difficult to predict where exactly the new fragilities are going to emerge, but it’s most likely to be somewhere unexpected or little scrutinised.

After the last financial crisis began in the banking sector, we saw wide-ranging changes to capital ratios and a much more stringent regulatory approach, so I don’t see scope for too much dislocation there this time.

The flipside is that a tighter focus on financial stability has driven a lot of money into the shadow financial sector, and we see leverage there – a risk if defaults increase.

Furthermore, part of the fragility is the transition away from fossil fuels to clean energy. The world has effectively stopped investing in fossil fuels but not yet replaced it with sufficient capacity from renewable and clean energy sources. While in the long term the transition to net-zero carbon economy will result in lower energy prices, in the medium term it’s a source of inflation and macroeconomic uncertainty.

Where is the alpha?

In this new world – where central banks no longer have investors’ backs – active security selection is essential to take advantage of the volatility, the divergence and the dispersion.

Asset selection will be more driven by fundamentals and therefore reward a bottom-up research-driven approach. That is where you will be able to generate your alpha.

We think that alternative and unconstrained strategies with a global and absolute return focus offer greater diversification benefits than traditional fixed-income and benchmark-hugging approaches. We also see opportunities in distressed credit and selectively in emerging market assets.

The brave new world

Two key drivers of the ‘Great Moderation’ – globalisation and demographics – are fading and higher inflation has brought an end to the era or low and negative interest rates and ‘QE-infinity’ that favoured passive relative to active investment strategies.

More frequent extreme weather events associated with global warming and efforts to mitigate climate change will be a source of greater macro uncertainty and market volatility.

Investors must respond by thinking global and looking for alternative sources of diversification and return.

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