Say Goodbye…to Great Moderation?

Let's widen the lens and ponder the possible transition we're in the midst of, to perhaps a different secular environment. The secular era that preceded the pandemic is often referred to as the Great Moderation; one during which disinflation reigned, economic volatility was subdued—save for the global financial crisis—and there was a steady tailwind associated with the epic decline in interest rates.

The Great Moderation era doesn't have an official start point, but in general it's seen as kicking in during the 1990s, although some references date as far back as the early 1980s. The era was punctuated by a number of key characteristics in addition to low economic volatility and disinflation; including longer economic cycles with less frequent recessions, a Fed quick to press the easy policy button all the way to zero, profits representing an outsized share of gross domestic product (GDP), and a positive correlation between bond yields and stock prices.

The era that preceded the Great Moderation and started in the mid-1960s—which we've been calling the Temperamental era—had a very different set of characteristics. They included heightened economic volatility with more frequent recessions (but sharper expansions), as well as greater inflation and geopolitical volatility. It was also an era when labor, via wages, represented a much larger share of GDP relative to profits, and when there was a consistent negative correlation between bond yields and stock prices.

The switch was initially flipped due to the severity of the profits recession as the tech bust was unfolding. Profits took a hit again during the financial crisis, but since then have been in a range near record highs as a share of GDP. Conversely, even with the brief spike during the pandemic, labor's share of GDP hasn't picked up to where it was a few decades ago. Yet, another convergence has begun, and this is key to watch to get a sense of whether we are transitioning into an era that might look more "temperamental."

In a recent report, the brilliant macro folks at TS Lombard took on the subject, titling the missive with "A Big Shift Everyone Would Rather Ignore." In it, they posit that "all the basic tenets of neoliberalism are under attack. Governments everywhere are running massive deficits (even at full employment), globalization is retreating, and public officials have even tried their hand at 'price controls' in a desperate attempt to contain the cost-of-living crisis. Yet it is the sudden popularity of industrial policy that takes the attack on a new neoliberalism to new extremes. What this means is deliberate attempts by governments to reshape the economy according to their own strategic ideas. Twenty years ago, such interventions were unthinkable. Today they are becoming the new normal."

There is no question we are seeing profound geopolitical shifts internationally, with the re-emergence of big geostrategic power rivalries (e.g., China vs. the United States and NATO vs. Russia). Perhaps it's wishful thinking, but we find ourselves—at least at this stage in the possible shift—in agreement with TS Lombard's less-pessimistic perspective. The more optimistic view is that "this new era won't be as bad as most assume, especially after a decade in which most economies seriously underperformed." The exclamation point on this view is that "you would have to be extremely myopic to think interest rates at 800-year lows were a 'good' thing, especially given the increasingly toxic political environment they were producing."

That was followed by a choppy transition around the bursting of the tech bubble; but from that point until the pandemic, the correlation was mostly positive other than during the height of the financial crisis. The explanation for this was, for the most part, disinflation. When yields were rising during this era, it was typically reflective of improving economic growth without an attendant inflation problem—a great environment for stocks. The opposite was the case when yields were falling.