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The Post-New Normal Era

As featured in Bloomberg Prophets, GAM Investments' Larry Hatheway believes that higher US wage inflation is leading market participants to doubt that the Fed can remain committed to "gradual normalisation."

Friday, April 06, 2018

A shift in sentiment

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 US wage inflation. Although a few data points aren't conclusive evidence, market participants have begun to doubt the Fed can remain committed to "gradual normalisation." The implications of such a shift in sentiment cannot be overstated.

Among other things, the market is now more vulnerable to other shocks. Concerns about US protectionism or signs that key leading indicators—among them European purchasing manager indices—may have peaked now matter more, given that market participants can no longer count on the Fed to smooth possible bumps in the road.

Importantly, signs that US inflation may be accelerating confirm investor expectations. Since September 2017 "breakeven" rates of US inflation have been rising. As they do, so does the possibility that inflation won’t come to rest at the Fed’s target, but might actually overshoot.

That matters. Overshooting inflation would herald significant changes in monetary policy. After all, even after the latest Fed rate hike, real US short-term interest rates are negative and the central bank's balance sheet remains bloated. And despite the recent market tumult, financial conditions remain accommodative in the US and globally.

In addition, US growth has accelerated, the unemployment rate has dropped to levels typically associated with full employment, and Washington is delivering a hefty dose of fiscal stimulus in 2018.

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.

Lingering uncertainty

Why else does this matter for markets? Consider that strong equity performance in 2017 was underpinned by three pillars: accelerating global growth, surging corporate profits, and predictable monetary policy.

The first two remain largely 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 US also aren't yet at risk.

Yet monetary policy, which investors did not question even after the Fed and other central banks initiated "normalisation," may be changing. If it becomes less predictable, then equity valuations must fall and the bond term premium must rise.

Lingering uncertainty, accompanied by protectionism and political risk, suggest that markets are unlikely to recover rapidly. Investors must brace for a world of lower returns, accompanied by bouts of volatility.

Portfolio management must adjust. Capital preservation will become more important. But the transition away from the ‘new normal’ also offers opportunity. Tactical asset allocation will become more rewarding — and more risky — as market volatility returns to more customary norms. 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, as bond yields resume rising, fixed income assets 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.

In short, the ‘new normal’ of low growth, low inflation and low interest rates is drawing to a close. The catalyst is the arrival of inflation, as economies in North America, much of Europe and Japan draw down spare capacity.

As monetary policy adjusts, so too will markets. Broad trends will give way to lower returns accompanied by greater volatility, and greater dispersion of performance. Portfolio construction must adapt, and the skill of focused active management will be in demand.

Originally published in Bloomberg View 2018. Reprinted with permission. The opinions expressed are those of the author.



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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.