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In the past I’ve written in detail about how markets are constantly evolving – after all, changes in fixed income were the genesis behind starting Wavelength. And while day-to-day price moves offer the most apparent (and noisy) examples of markets changing, at the other end of the spectrum are the rare and transformative paradigm shifts that change markets for the long term. These transitions are something I am focused on because they can have the greatest impact on what works when investing, and I see increasing evidence that we are going through one today.
Some Historical Context
Taking a step back to look at the broader history of financial markets, different paradigms experienced over the years become clear: the monetary system’s breakdown in the 1960s, stagflation of the 1970s and early 1980s, disinflationary growth into the late 1990s dot-com bubble, and the debt-fueled growth of the 2000s ending painfully with that debt bubble bursting in 2008. Each of these environments had a distinct set of conditions that was ultimately unsustainable, and the last inflection point – coming in the form of the global financial crisis – was a formative experience for many investors (myself included) with a policy response that paved the way for the bulk of market conditions we’ve experienced since.
Figure 1: Timeline of Market Environments
Source: Wavelength Capital Management
Understanding these transitions is critical because the forces behind each environment naturally come up against limitations, and eventually markets shift into the next paradigm with a different set of relationships. This process can be painful when people extrapolate to make investment decisions based on factors that are no longer in place, so identifying what drove asset prices in the previous environment and what has changed is essential – particularly at a turbulent time like this.
Era of Easy Money
The global financial crisis ushered in a new era for markets when the Federal Reserve cut the base interest rate in the economy to its lowest level ever. This unprecedented monetary policy was then augmented further with the outright purchasing of bonds by central banks. Thinking back on the situation – as Lehman Brothers and other firms were collapsing and, on a personal level, I was seeing friends lose jobs across Wall Street – the ultimate backstop these policies provided was remarkable.
With this, a deluge of liquidity flooded the financial system, lowering borrowing costs for businesses and aggressively stimulating growth. Having next to no return on cash, people were encouraged to make riskier investments, giving companies additional capacity to expand as their profits and values rose. All of this took place amidst a backdrop of globalization that expanded the market reach of many companies while lowering their input costs. This dynamic, along with the growth of ecommerce and other technological advances, made goods and services cheaper – confounding many pundits’ calls for runaway inflation. And with few disruptions from armed conflicts and other tensions over the period, these conditions were largely in place until the pandemic upended the economy, global trade, and in many ways life as we knew it.
Up to that point, the US economy was in the midst of its longest expansion on record and the prices of financial assets over the post-GFC period rose to extraordinary levels. From its low in March of 2009 through mid-February 2020, the S&P 500 Index gained over 500%, and corporate bonds rallied similarly as yields measured by the Bloomberg US Corporate High Yield and Investment Grade Indexes reached their lowest levels on record. In this context, investor optimism was abundant, and external forces driving inflation downwards let central banks keep rates at extraordinarily low levels for much of the period. At the end of the day, a risk-free rate near zero encouraged investors to take risk across the spectrum of financial assets, and its rapid rise over the past year is the clearest point of distinction between the post-GFC period and what we now face.
A Bumpy, Pandemic-Induced Transition
Outside of the pandemic’s tragic toll on public health, the associated economic shutdown and policy responses changed the shape of the economy. As they did in the financial crisis, central banks cut interest rates dramatically and purchased securities through quantitative easing to support the financial system. Governments in the US and elsewhere further encouraged growth through spending programs and direct stimulus checks. These policies helped prevent disruptions from intensifying the economic damage that resulted from public health measures, but as we now see clearly, their impact on demand in the form of household spending combined with supply chain issues and geopolitical tensions to produce the highest levels of inflation in decades.
As it became clear that the inflation taking hold in the economy was not transitory, central banks across the globe shifted gears into what has been one of the sharpest and broadest hiking cycles on record. Though slow to the uptake, the Federal Reserve has now raised rates by close to 5% since March of 2022, aggressively closing the door on the era of easy money. With this policy overhaul, longstanding conditions that investors had grown accustomed to over the post-GFC period are no longer in place and cannot be relied upon for investment decisions as we enter a new environment.
Adapting to a New Paradigm
While it’s a considerable challenge to know what will happen next with markets, it’s much easier to see what has changed. After a period of extraordinarily low rates, expanding global trade, and muted economic volatility, each of those conditions is now on a profoundly different trajectory that has meaningful implications for portfolios. These changes are set to have different effects on markets and investment strategies, the beginning stages of which we are just now starting to see. In this, conditions for many companies and their profit margins are less favorable than they had been in the prior regime, but lending at higher rates isn’t bad for the prospects of all asset classes and the return to a more “normal” financial environment will not treat all markets equally.
Investors must now face an environment where higher borrowing costs, increased trade frictions, and greater volatility across economies present a wholly different set of risks and opportunities. In this context, I expect fixed income to reclaim its role as a critical component of portfolio performance with balance to potential economic outcomes providing a key advantage when managing risks as markets adjust to the new paradigm.
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