- The Federal Reserve’s plan to let inflation heat up could undermine decades-long regimes in markets and the economy.
- Higher inflation raises cyclical assets and hits Treasury and high-grade corporate bonds.
- A period of constantly high inflation and strong growth could replace the weak expansion of the past decade.
- See more stories on the Insider business page.
Regime changes are generally identified years after they first appeared.
LeBron James’ decision to take his talents to South Beach ushered in a new era of NBA “superstars”, brought together by friendly superstars who coordinated their movements through free agency. The Tony Stark interpretation, also known as Iron Man, by Robert Downey Jr., in 2008, set the stage for a new box office giant (and now in streaming). And like it or not, Mark Zuckerberg’s invention of Facebook brought a paradigm shift to online privacy and socialization.
Federal Reserve
President Jerome Powell may be next. Investors are gearing up for inflation in the still nascent Biden era. But the way the Fed guides the economy forward will decide whether markets are in the midst of their own regime change or whether investors can reuse their pre-pandemic manuals. The moment seems to be the beginning of a new era in the markets.
The central bank launched a new policy framework in August that targets inflation temporarily above 2% and maximum employment. Powell’s comments have since indicated that the Fed’s extremely easy monetary policy will remain in place long after the economy reopens.
The orientation, although vague, marks a radical change in the recovery after the global financial crisis. The initial leap of the Great
Recession
it quickly gave way to secular stagnation, a phase coined by the famous economist Larry Summers to describe a period of weak growth and low inflation.
The Fed’s new strategy aims to learn from the latest recovery and heat up the economy, contrary to the decades-old precedent that explicitly links price growth to hiring.
“There was a time when there was a close connection between unemployment and inflation. That time has passed,” Powell told a news conference on Wednesday. “We had low unemployment in 2018 and 2019 and in the beginning of ’20, without any worrying inflation.”
Laying a foundation for the next decade of earnings
Recession recoveries show similar market dynamics in their early stages. Investors dispose of defensive assets like Treasury bills and growth stocks and move their money to riskier vehicles in the hope that stronger economic growth will raise its value.
These negotiations have largely ended. Treasury yields have reached their highest levels in more than a year, with investors positioned for stronger inflation. Technology stocks plummeted in February, and sectors left behind during the pandemic outperformed.
The past few weeks have been more eventful. Technology sales were followed by falling purchases, as traders shifted their focus from inflation concerns to the reopening of optimism and vice versa. The 10-year yield continues to rise, but at a slower pace than seen in early March. The markets are apparently at a crossroads, waiting to see how strong the recovery will be.
“We are in the early stages of a regime change, where perhaps easy money has been made,” said Rich Steinberg, chief market strategist at The Colony Group. “I would love to say that there is a manual that you can follow that will give you the secret sauce on how to be directionally correct throughout this movement. I don’t think this secret sauce exists.”
Source: The Colony Group.
The Colony Group
Certainly, the change in market leadership still has a long way to go before reversing almost a decade of growth dominance. Except for a short period in 2015, these shares easily outperformed their counterparts in value after the financial crisis, as the scenario of low growth and low inflation increased their appeal.
The aggressive fiscal stimulus and the maintenance of easy monetary policy by the Fed can change that. The combination could overwhelm economic growth and inflation to levels never seen before the late 2000s and 2010, said Jason Draho, UBS’s head of asset allocation in the Americas, in a note.
The Democrats’ plan to approve a major infrastructure plan should give even greater impetus to cyclical assets, as well as increase productivity and long-term economic growth, he added.
If stocks of value and recently unloved sectors become the new market winners, the growth giants and treasures that have thrived for more than a decade are likely to lose. Growth stock valuations are closely linked to interest rates, as investors project the company’s long-term expansion and use rates as a discount tool. Higher rates affect the future profits of these companies and, in turn, the appreciation of their shares.
Higher inflation is also “an enemy of fixed income” and is likely to drag investment-grade government bonds, mortgages and corporate debt, said Todd Jablonski, chief investment officer at Principal Global Asset Allocation.
“At the current level of low rates, what is being seen in fixed income is a very expensive proposal for stability, and not as much revenue as one could wish for,” he added.
Wall Street: money never sleeps
YouTube / 20th Century FOX
A whole new world, or business as usual?
It is still too early to say whether the economy is entering a new expansionary cycle or starting the kind of regime change that occurs only once every few decades, Jablonski told Insider.
The last major regime change was undoubtedly the dot-com boom in the late 1990s and early 2000s. The advent of the Internet and a new wave of technology companies kicked off the technology sector as seen so far. today.
Looking further back, the “Great Inflation” that dominated the 1970s and ended the unprecedented rate hikes by former Fed chairman Paul Volker marked another major change. Retaliation against the high-rate environment materialized in the 1980s with new mentalities: profit rules everything, drip economics and, as the fictional financier Gordon Gekko famously did, the philosophy that “greed is good”.
The type of regime that materializes after the pandemic depends on how much inflation the Fed feels comfortable allowing, said Jablonski. The CIO said it expects price growth to peak at 3% during the recovery, but that increase is expected to decline rapidly shortly thereafter.
If there is enough momentum to boost “real, organic and private inflation” after that peak, the country can finally resist the era of low growth and low inflation, said Jablonski.
“The question is, after that peak … where do we settle? Do we set it at 2.5% or 2%? There is a huge difference between these numbers!” he added.
The market’s reaction will not come overnight. The asset classes that thrived under previous regimes only started to decline well after the relevant central banks raised rates several times. The Fed’s latest projections suggest that its first post-pandemic rate hike will not arrive until 2023, leaving enough time for the market to oscillate between regime change positioning and a return to last year’s norms.
Source: The Colony Group.
The Colony Group
Trying to time a regime change and the related bubble burst “is extremely difficult and can be extremely painful if you are on the wrong side of trade,” said Steinberg of the Colony Group.
While the timing of the change is hazy, the market is increasingly likely to be on the verge of seismic change, said Draho. The continued support of the Biden government and the Fed could replace the bearish regime for the longest time seen in the past decade with an impulse to heat up the economy.
“What seemed unlikely six months ago is becoming more and more plausible and investors need to be prepared,” added Draho.
The key, for now, is composure. The Fed said it would “be patient” in waiting for inflation to peak and then stabilize at a high level before withdrawing its historic monetary support. Investors may be tired of the central bank’s ambiguity, but the balance between the overheating of the economy and the repetition of a phase of secular stagnation is difficult to find.
“The Fed is the snail on a razor’s edge. And they are trying to be careful to live, to get through it, but also not to move too fast and be cut,” said Steinberg.