Markets Face a New Paradigm. Get Used to It
The period of financial markets being supported by central banks' easy money policies is ending. Higher equity prices will now require evidence of stronger growth and moderate inflation, meaning it is unrealistic to expect selloffs to be followed by sharp rebounds as quickly as they have in the recent past.
Since 2009, investors have done well to "buy the dip" in equities and many other assets, as pullbacks were quickly reversed in a V-shaped pattern. But three things are different this time, and maybe what will emerge are trading strategies that look more like "buy the U" or "buy the drain pipe":
- You're no longer sure the Federal Reserve is your friend.
- The Phillips curve theory, which states that a tight labor market will fuel wage gains and inflation, may not be dead after all.
- We now need help from the economic data.
A friendly Fed cushions investors when asset prices drop down the elevator shaft. An unfriendly Fed smiles as they go by. The central bank was structurally friendly when growth prospects were stagnant and inflation was below target. It did not want to take the risk that a financial-market shock would take inflation further below target. Now, it is trying to look like a true central bank, sounding optimistic on the economy and indifferent to market moves. This is relatively easy, because even though the S&P 500 Index technically entered a correction by closing down 10 percent from its recent high, it is still up more than 25 percent since before the November 2016 U.S. elections.
To be sure, the Fed's rhetoric could change if an otherwise healthy correction risks affecting activity or devolves into general market panic. Policy makers will probably start making market-friendly comments if equities fall about 15 percent from the peak. That would roughly correspond to a level of 2,500 for the S&P 500, which was also the launching point for the late-2017 surge in equities.
The Fed's hawkish tones of late have been driven by the run-up in both expected and realized inflation. The core personal consumption expenditure price index over the last six months exceeds 1.7 percent on an annualized basis. So, unless we get some disinflationary data and labor costs stabilize, the Fed will feel a lot closer to its 2 percent target than a few months ago.
A less friendly Fed equates to higher asset market volatility, and changes the distribution of potential outcomes in markets and increases volatility, which means risk-adjusted returns diminish. A friendly Fed curtails the dreaded "fat tail" to the left, while an unfriendly one restores the no-policy-reaction to market moves.
The Cboe Volatility Index, or VIX, has surged from about 10 to an average of 27 this month. Such an elevated VIX is unsustainable if the Fed is simply tolerant of a correction. For the VIX to remain at these levels there needs to be a sustained sequence of bad news that would open the door to a steeper drop. If the increase is tied to the malfunctioning of certain equity-market products, then the VIX should return to normal after the debris is cleared. But "normal" is not likely to be as low as it has been when the Fed is approaching its inflation target instead of undershooting. Barring positive news, it would mean that the equilibrium level of equities is lower.
What's encouraging is that there are no signs of significant economic weakness. As long as inflation is accelerating at a measured pace, the Fed can keep describing the likely pace of interest-rate increases as "gradual." This still means higher volatility than we were accustomed to in the fourth quarter and earlier this year, but much lower than recent weeks.
There are reasons not to be so worried that inflation is poised to surge, but that is not the same as knowing for sure that there is nothing to be worried about. The problem for investors is that supply-side data are not very good on a real-time basis and are released infrequently. The hope is that there is a pickup in productivity and growth that mitigates the inflation effects of tighter labor and global asset market, but we may have to wait.
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