It’s goodbye to Great Moderation, and hello to Great Volatility

“We are braving a new world of heightened macro volatility and higher risk premia for both bonds and equities.” Blackrock analysts

IF investors think the volatility that has rocked global markets this year is transitory, they are in for a shock.

The post-pandemic inflation and energy shocks could be the final nail in the coffin of “The Great Moderation” – the years of low inflation, low interest rates, steady growth and deepening globalisation from the mid1980s to the global financial crisis (GFC) of 2007-2009.

The Great Moderation held down macroeconomic volatility, depressing financial market volatility and allowing asset prices to flourish, from stocks and bonds to commodities and credit.

Monetary policy

Central banks also rode to the rescue in times of market or economic stress like the GFC with easier monetary policy, without unleashing significant inflation. This extended the Great Moderation and added fuel to the asset market boom.

That world appears to be gone and policymakers know it – speeches by Augustin Carstens of the Bank for International Settlements and the European Central Bank’s Isabel Schnabel at the Kansas City Federal Reserve’s Jackson Hole symposium last week stressed the importance of “macroeconomic stabilisation.”

Prolonged higher inflation, higher interest rates, erratic growth and protectionism – a world of structurally higher “macro vol” – is likely to foster wider market volatility, making investing much trickier and riskier.

With the US Federal Reserve (Fed) and other central banks focused on quelling inflation, investors can no longer rely on the so-called “central bank out” of looser policy to support markets in times of stress.

Schnabel was clear that central bank actions will determine whether “the challenges we are facing today will lead to the Great Volatility, or whether the pandemic and the war in Ukraine will ultimately be remembered as painful but temporary interruptions of the Great Moderation.”

Eurozone gross domestic product volatility over the past two years was about five times higher than the peak of the Great Recession in 2009, and inflation volatility has surged beyond 1970s levels, according to Schnabel.

Strategists at Blackrock, meanwhile, estimate that US growth and inflation volatility are at levels not seen in almost 40 years.

“We are braving a new world of heightened macro volatility, and higher risk premia

for both bonds and equities,” they wrote.

Macro volatility

“We didn’t see market volatility breaking into a higher regime unless macro volatility did as well. Now it has, and we could go back to the volatility seen in the 1970s.”

Generational shifts on a scale like this do not happen overnight, but Covid-19 accelerated this one. Near-term visibility is negligible, never mind the medium and longerterm outlooks, which is partly why markets remain so rocky.

Battered markets

The burst of volatility since the Fed started raising rates has battered financial markets.

US equity volatility is higher. The mean daily reading this year of the Chicago Board Options Exchange’s Volatility index (VIX), an options-based indicator that reflects demand for protection against drops in stocks, is 25.6. In the five years before the pandemic, it was 15.

Underlying volatility has jumped too. Daily mean realised volatility in the S&P 500 over the five years to March 2020 was 12.8. This year it is 21.6.

The surge in bond volatility is even more stark. The three-month Intercontinental Exchange BOA Merrill Lynch Option Volatility Estimate index, which tracks treasury yield volumes, hit 140 earlier this year, a level not seen since 2009. It remains super-charged.

Unsurprisingly, returns have been obliterated. Analysts at Truist Financial Corp say a typical 60-40 US portfolio of stocks and bonds is down 12.25% from Jan 1 to Aug 26.

That would be the sixth-worst year on record in data going back to 1926.

Analysts at Barclays also carried out a deep dive recently into the Great Moderation.

They argue the pandemic shocks to global supply, growth, inflation, energy and labour markets will become more permanent and investors should brace for “less stable macroeconomic outcomes and a more complicated environment for asset pricing.”

They argue that the link between employment and inflation, the Phillips Curve, could be re-emerging. If it is, inflation is likely to be higher, and so will macro volatility.

Before the pandemic, a sustained fall in the US unemployment rate of one percentage point lifted inflation only by 0.1 to 0.2 percentage point (pp), they note, well below the 0.3 to 0.7pp rise triggered in previous decades.

As if that were not enough, these shifts are taking place amid the steady reduction in overall market liquidity following the Great Financial Crisis of 2007-09.

Structural changes

As Chris Marsh, senior adviser to Exante Data and a former economist at the International Monetary Fund, notes, regulatory constraints have forced investment banks to cut risk, so they no longer play the market-making and liquidity-providing roles they once did.

If central banks are not providing a backstop any more, the game definitely has changed.

“These structural changes imply more volatility,” Marsh contends.