Modeling the end of the Great Moderation

The past three decades exhibited slow economic growth, declining interest rates and low volatility. Now we are entering a new era.

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May 9, 2022 | 10 minute read

The macro environment of the past few decades—dubbed the Great Moderation—has delivered long business cycles, slowing economic growth and windfalls for investors in equities and fixed income. Recently, a powerful blend of forces has challenged the tenets of the incumbent era, a prospect with huge implications for both the economy and capital markets. In this paper, we examine this critical inflection point and present analysis through our various investment models that were built to navigate such environments.

Executive summary

The end of an era

  • The Great Moderation—which we can loosely define as the macro regime that presided over much of the 1980s through the 2010s—may be coming to an end. The era has been characterized by slowing economic growth, low macro volatility, long expansions and relentlessly declining interest rates. The factors contributing to this backdrop are numerous—aging demographics, technological change, a more intrepid monetary policy and globalization, to name some of the primary drivers. The Great Moderation has been a boon for traditional assets but has also introduced large problems, both political and economic, that today are helping to drive a shift toward a new macro regime.
  • Signs of a burgeoning new global order are plainly evident in today’s environment. Inflation in the U.S. has proven persistent and has broadened from a select group of durable goods to now services, energy and food. Geopolitics has been upended by a bellicose Russia and more insular China, forcing the developed world to rethink alliances and supply chains. And fiscal policy appears to be making a comeback, first with the aggressive response to COVID in the U.S., and now as Europe plans to spend hundreds of billions of euros for military and climate endeavors. While demographics and technology remain disinflationary forces, the personality of this new era will likely be higher spending—both at the corporate and sovereign levels—higher and more volatile inflation, and shorter business cycles. This will be a game-changer for asset markets.

Markets are braced for impact

  • Equities and bonds reaped the benefits of the Great Moderation. On the fixed income side, the 10-year Treasury yield fell from nearly 14% in the mid-1980s to below 2% at the end of 2019, driving robust price gains for rate-sensitive bonds. Lower discount rates lifted valuation multiples for equities, which also profited as globalization and technological advances drove an impressive secular increase in free cash flow margins. The traditional U.S. 60/40 portfolio returned 9.4% per annum over the 30 years ending in 2020, a remarkable run of wealth generation.
  • The pertinent questions for investors now relate to interest rates and margins. The recent sharp rise in interest rates, driven by inflation and central banks’ reaction to it, has sent ripples through markets. Profit margins, which sit at record highs, may be pressured by deglobalization, onshoring and higher cost of capital. The reality is that most investor portfolios are long duration and highly weighted toward the sorts of companies that have benefitted most from trends brought on by the Great Moderation, making this a precarious time.

Investors need a new model

  • Complexity and data density in financial markets have been on the rise for years. The sheer volume of data available to investors has made quantitative models a near necessity, but has also made their job of separating signal from noise a daunting task. The seminal shift in the macroeconomy and markets that we have outlined will only add to this complexity. Our Strategic Domain model, which has been core to our investment process for years, continues to act as our compass in navigating the full market cycle. It has favored Value stocks in the U.S. since June 2020, and since then the top quintile of Value stocks have outperformed the broader market by 4,300 bps.
  • The speed and ferocity of the current cycle has forced us to enhance our approach to modeling with the development of a new model, called Tactical Domain. Swings in the relative performance of equity factors have been intense as markets attempt to forecast cycle inflection points. This model is focused on the short-term and is optimized for 3–6 month holding periods. Our backtest, along with the results of the model since its inception in late 2020, shows it is additive as a complement to Strategic Domain. Our view is that as the world undergoes profound geopolitical, economic and financial changes, markets are likely to remain more volatile than investors experienced during the Great Moderation era. The ability to access proven models will be paramount as markets enter an environment that is familiar to no one.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Andrew Korz, CFA

Executive Director, Investment Research

Brian Cho, CFA

Managing Director, Head of Quantitative Research, FS Chiron Funds

Lara Rhame

Chief U.S. Economist + Managing Director

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