Hi, everyone. I am Liz Ann Sonders, and this is the July Market Snapshot. This video will be about a contrast in eras, specifically the end of the so-called Great Moderation era, and what to expect looking ahead.
[Table for "A study in contrasting eras" showing characteristics of Temperamental and Great Moderation Eras is displayed]
Now, we first wrote about this three years ago when we pondered the idea that the Great Moderation Era, which defined the two-plus decades leading up to the pandemic, whether it was ending. That was an era marked by disinflation, suppressed market volatility, cheap access globally to goods, energy, and labor. And I'm more convinced than ever that the current and/or next secular backdrop may look a bit more like the 30-year period that preceded the Great Moderation Era. So that period from the mid '60s to the mid '90s, we are labeling the Temperamental Era.
Like during the Temperamental Era, we expect that inflation is likely to be more volatile, the geopolitical landscape will continue to be unstable, and supply shocks may be more frequent and powerful. And this represents a new operating environment for both the markets and the economy.
[High/low chart for "More inflation volatility ahead?" for year/year % change in CPI is displayed]
Now, there's a clear distinction between the level of inflation in each of the two eras, as you can see here, more recently with inflation driving higher on the back of the pandemic-induced surge in 2022. And we do not believe we're likely to see quite the level of heightened volatility as what existed during the original Temperamental Era, especially in the 1970s, but we do believe the Federal Reserve's 2% inflation target will be more difficult to hit, and that inflation could operate in a wider range than was the case during the Great Moderation Era.
[High/low charts for "Yields reconnecting to inflation?" for Rolling 1-year and 30-day correlations between S&P 500 and 10-year Treasury yield is displayed]
Now, one of the most important differences between the two eras was the relationship between bond yields and stock prices. At its core, the difference was driven by inflation and the bond market's reaction function. So during the Temperamental Era, the 10-year yield tended to key off inflation, which meant rising yields were a reflection of higher inflation, and therefore troublesome to equities. The opposite was the case when yields were falling. During the Great Moderation Era, inflation was more subdued, which meant the 10-year yield tended to key off economic growth, which meant rising yields were a reflection of stronger growth. Without attendant higher inflation, that was very beneficial to equities. And of course, the opposite was the case when yields were falling.
Now, as a sign of a potential new version of the Temperamental Era upon us, the lower chart is a shorter-term correlation between the two. That's on a rolling one-month basis. And you can see that correlation has moved decisively into negative territory, highlighting that inflation risk is front and center again.
[High/low chart for "Sharp slowdown in net migration" for Net international migration is displayed]
Now, the picture of the labor market is more nuanced as it relates to the inflation backdrop. So wage pressures have moderated from their post-pandemic peaks, but the demographic headwinds that we flagged in our original report three years ago, including the rising age dependency ratio both in the United States and globally, that continues to tighten long run with labor supply. And exacerbating the supply issue is the fact that immigration has slowed down sharply in the United States, with expectations down to only about 320,000 this year based on current trends.
[High/low chart for "Profits continue to dominate" for Corporate profits as % of nominal GDP and employee compensation as % of corporate GDP is displayed]
Now, one of the starkest distinctions between the two secular eras has always been the relative claim of labor and capital on the economy's output. As shown here, during the Temperamental Era, employee compensation represented a larger relative share of GDP versus corporate profits. By the way, do notice the different scales on this chart here. That relationship flipped decisively as the Great Moderation Era took hold, as you can see. From the dot-com bubble burst onward, profits surged to record highs as a share of GDP, and that was aided by globalization, suppressed wage costs, the so-called "Fed put," which was the belief at the time that the Fed would backstop asset prices, and also a steady decline in unionization and labor's bargaining power. Labor's share, meanwhile, drifted lower for two decades. You did see a brief spike during the pandemic as profits cratered, but then those quickly reverted.
Now, here it may be a while before there's a convergence with these two forces. We may not see this go back to looking like the Temperamental Era. In fact, if the AI capital spending super cycle does deliver on its productivity promise by automating cognitive work, compressing labor costs per unit of output, expanding margins in software-intensive industries, if that were to unfold corporate profits could sustain an elevated share of GDP even as nominal wages rise.
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So let me sum it up. Our conviction continues to be that a new version of the Temperamental Era is not a bad one that lacks opportunities for investors. It's just a different environment from what has faced investors over the past quarter century. With the Great Moderation Era firmly in the rear view mirror, the question moving forward is how long a new version of the Temperamental Era will last, how it will differ from the one in the 1960s through the 1990s, and whether AI-driven productivity will eventually help offset the inflationary impacts from negative supply shocks over the past several years.
We remain constructive and open-minded regarding the opportunity set that investors have in this new era, but we also encourage folks to be realistic when it comes to how different the backdrop will look. We expect more frequent bouts of inflation volatility. That represents tougher trade-offs for policymakers. And we also expect greater dispersion in equity market returns. And those are among the dynamics that favor diversification within asset classes among sectors. We do not see stock and bond yield correlations durably flipping back to positive territory anytime soon, which does mean that inflation will likely continue to be a dominant driver of market behavior.
Thanks for tuning in. I'll be back next month.
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