Welcome to the Post-New Normal Era in Markets
Get ready for the post-new normal.
Recent market volatility reflects more than just an unwinding of positions or the failure of a few esoteric volatility products. The catalyst for the selloff arrived on Feb. 2 in the form of higher-than-expected U.S. wage inflation. Although a few data points aren't conclusive evidence, it won't be long before market participants begin to doubt the Fed can remain committed to "gradual normalization." The implications of such a shift in sentiment cannot be overstated.
Yes, positioning and market structures have exacerbated market moves. The unwinding of consensus positions in global equities and in trades that would benefit from subdued volatility meant that losses in those markets were more pronounced than elsewhere. Oil prices were another positioning casualty.
But this was not a mere "risk-off" episode. Had it been, bond yields would have fallen, not risen.
Importantly, the acceleration of U.S. wage inflation -- further buttressed by data released Wednesday that showed the consumer price index rose by 0.5 percent in January, the most in five years -- confirmed investor expectations that had been shifting since September 2017. "Breakeven" rates of U.S. inflation had been on the rise over the past five months. By now, market expectations for rising inflation include a possibility prices could exceed central bank targets.
That matters. Accelerating inflation may require significant changes in monetary policy. Even after Fed rate hikes, real U.S. short-term interest rates remain negative and the central bank's balance sheet remains bloated. Until the recent selloff, financial conditions had eased over the past year -- equity prices rose, bond yields remained low, credit spreads tightened, credit standards eased, and the dollar fell.
In addition, U.S. growth has accelerated, the unemployment rate has dropped to levels typically associated with full employment, and Washington is delivering fiscal stimulus via tax cuts and fresh spending.
That means even a modest acceleration of inflation can shift monetary policy expectations. For equity investors worried about the downside, the "Powell Put," named after the new Fed chairman, Jerome Powell, surely has a strike price well below current market levels. If investors want protection, they'll have to pay for it. The Fed freebie won't be on offer until things get much worse.
Equity performance over the past 12 months was underpinned by three pillars: accelerating global growth, surging corporate profits, and predictable monetary policy.
The first two remain intact. There is scant evidence that an equity-market correction will drag down growth significantly. The underpinnings of the global expansion remain durable. Cyclical margin expansion in Europe and emerging markets, secular profits growth in Japan, and after-tax corporate cash flow in the U.S. also aren't yet at risk.
Yet monetary policy, which investors did not question even after the "taper tantrum" of 2013 or when the Fed and other central banks initiated "normalization," is finally changing. If it becomes less predictable, the equity valuations must fall and the bond term premium must rise.
What will it take for markets to recover?
First, because market positioning and derivative structures are opaque, the recovery is unlikely to be V-shaped. Investors will await some stability before looking for opportunity.
Even if the initial market reaction to the January CPI was benign, further signs of wage and price inflation acceleration are unlikely to be positive for equities. Moreover, the advent of higher inflation is probably not confined to the U.S. The upcoming public-sector wage settlements in Germany, following the significant gains won by the metalworkers' union, will be closely watched. Investors need to keep an eye on Japan, too.
In the post-new normal era, no asset class is immune from repricing. Equities must de-rate if inflation accelerates sharply. Bond investors will demand higher yields. Credit spreads will widen, as investors require a premium for potential illiquidity.
Still, this transition also offers opportunity. Tactical asset allocation will become more rewarding -- and more risky. Once the initial selloff is over, the dispersion of returns should be higher, creating opportunity for skilled active managers. The salad days of benchmark hugging, active or passive, are over.
Finally, if yields rise, bonds will deliver poor total returns and little diversification for multi-asset portfolios. Alternative strategies, those genuinely uncorrelated with equity and bond moves, need to step up and fill the gap.
The returns will be lower and volatility higher. And it will require more active decision-making to navigate markets effectively.
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