The last few years have been marked by several "once in a generation" events. In 2020 we experienced a global pandemic of a severity not seen since the Spanish influenza of 1918. Then, we had the largest ever combined fiscal plus monetary impulse that catapulted asset prices to extreme valuations. Finally came 2022, when we saw war in Eastern Europe and the most rapid increase in inflation in four decades.
Clearly not all these events are equal. From a humanitarian standpoint, the pandemic and the war were catastrophic. From a financial standpoint, inflation is the worst possible shock to an economy that had become completely accustomed to the extraordinary central bank accommodation that had been put in place the decade after the Global Financial Crisis of 2008. Inflation, as we said many times, represented a shock that had to be met by another shock (tighter policy), and the party ended. In other words, whereas the Fed had been able to meet downside shocks to growth with more accommodative policy in the low inflation regime of the previous decade, it no longer has this same luxury in the current high inflation regime and, quite the opposite, has been actively trying to tighten financial conditions.
Since Volcker, we have gone through five more hiking cycles.1 Almost all cycles triggered some form of negative market outcome, even though they were not as aggressive as the 2022 cycle. The 1994 cycle was followed by the Mexican and then the Asian crisis. The 1999 cycle was followed by the Nasdaq meltdown in 2000-2001. The 2004 cycle, when the Fed kept rates high until 2007, was followed by the Global Financial Crisis in 2008. Maybe only the 2015 cycle, the least aggressive of all tightening efforts, was uneventful.
There are many interesting dynamics in this chart:
A well-known fact of financial markets is that volatility is persistent (this is what GARCH models are all about - analyzing regime changes in market volatility, which tend to become more volatile during periods of financial crises or world events and less volatile during periods of calm and steady economic growth). The kind of shocks that we saw in 2022 are expected to have long lasting effects. The economy, and more importantly financial markets, will take time to settle after such seismic shocks. At the forefront it is still inflation and not only how fast will it come down, but whether it will rebound like it did in the 70s/80s episode. The outlook for corporate earnings is another notable issue. We mostly think about QE and low rates having pushed up equities through the PE channel. However, as the following graph shows, corporate profits exploded during the last decade. Part of the increase can be attributed to tax changes and inflation, but the largest part of the increase is unexplained.2
To sum it all up, we are in the middle of an unprecedented tightening of monetary policy. Furthermore, markets went into this cycle completely unprepared and mispriced for what was to come. Whether that is the Fed's fault or market failure is best saved for another write up, but the consequence is the same: a massive tightening of policy both in absolute terms and also relative to expectations. The Fed rhetoric has also changed considerably. For example, we learned from the December 2022 minutes that the Fed is concerned about an unwarranted ease in financial conditions. Contrast this with the previous decade, when the Fed's main objective was to avoid at all costs an unwarranted tightening of financial conditions.
The key takeaway for me is that we have a very long and volatile road in front of us, and as such it is critical to keep a close eye on the data but also to be tactical and open minded when thinking about market outcomes.
(1) We leave aside the 80's as the macro imbalances were huge in comparison to the decade after. Clearly there is a lot to learn from the 80's but when comparing cycles I believe it is best to just focus on the more "modern" post-1980 period.
(2) Source: Smolyansky, Michael (2022). "The coming long-run slowdown in corporate profit growth and stock returns," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, September 06, 2022, https://doi.org/10.17016/2380-7172.3167
Comparison between the forward curve at the outset of each tightening cycle and what the Fed delivered ex-post:
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