Back to the Future

The last year was one of sharp departures from past trajectories. Donald Trump, a firebrand former reality television host, among other ventures, won the US presidential election, bucking what had become a big money-dominated and closely controlled electoral process. His message was unabashedly nativist, flying in the face of decades-long trends such as globalization that were widely assumed to stay.

And he promised both massive tax cuts and public expenditures—prescriptions that had in recent memory been tied to either the Democrats or Republicans, but hadn’t managed to cross party lines.

Those promises of massive fiscal expansion reverberated through global markets and unleashed animal spirits that have been absent for nearly a decade. Asset prices galloped higher, adding more downside risk for asset owners. The S&P 500 climbed more than 20% for the year, with the Dow Jones Industrial Average up more than 30%.

The cyclically adjusted price to earnings (CAPE) ratio for the S&P 500—a measure of long-term valuations—was at 31.2 in October, almost double its 16.8 mean over the past 20 years. The 2.35% yield of the US 10 year Treasury was nearly half of its 20-year mean of 4.6%. Illiquid assets ranging from real estate to private equity were similarly frothy.

Those shocks in policy and return of animal spirits also resulted in a dramatically transformed market backdrop. Nine years after the financial crisis, the central bank-driven, risk-on or risk-off, highly correlated environment finally fractured in 2017. Central banks started taking the economy off life support. Rates rose with equities at long last—a sign that markets foresaw inflationary expansion, not just more quantitative easing ahead. Dispersions climbed. The US grew above trend, and there are even signs of wage inflation. Generational trends like the growth of emerging markets and their consumer wealth effect are again top-of-mind, with emerging markets breezing by their developed market counterparts.

Call it a “New, New Normal,” a point where markets finally moved beyond the famed “New Normal” of the deflationary stagnation that defined the post-financial crisis era.

Forward-thinking market participants are coming to grips with the new market reality. “The great shadow of the financial crisis of 2007-2009 may finally be lifting from the global economy,” Erik Knutzen, chief investment officer, multi-asset class, at Neuberger Berman, wrote in a research report in October.

Strong global growth (for two years now, every major region in the world has seen its GDP grow) following persistently deflationary conditions in the wake of the financial crisis underpins the new market environment.

“Over the summer, we learned that all 45 of the economies tracked by the Organisation for Economic Co-operation and Development (OECD) are growing. It is the first time in a decade that this has been the case. Moreover, growth is accelerating in 33 of the 45,” Knutzen wrote. “We are experiencing a relatively rare period of extended, synchronized global growth, a defining aspect of the ‘Goldilocks’ environment of steady growth, low rates, and low volatility,” the firm had predicted in a prior forecast.

The theme of global growth set the pace for the world’s stock markets.

“This year has been characterized by two broad themes in equity market flows. The first has been the flow of capital toward the ongoing economic recoveries in Europe, Japan, and the emerging world. We believe these trends are sustainable given the background of synchronized global growth and moderate inflation, and, at the large-cap level, the slightly stretched valuations in the US relative to the rest of the world,” Knutzen wrote. “The second, even stronger theme has been the flow of capital toward larger, somewhat defensive, growth-oriented companies, which has left smaller, more cyclical stocks lagging.”

The pile into technology stocks like Facebook, Apple, Netflix, and Google shows investors’ desire to capture growth.

“This global phenomenon has really been exemplified in the US by the flows into high-quality, large-cap exporters and multinationals, and the so-called ‘FANG’ stocks from the technology sector,” Knutzen wrote. “These are companies that either benefit from global growth and a weaker dollar, or can grow earnings without broader economic growth. Softness in inflation data, flattening yield curves, and a weakening US dollar appear only to have heightened investors’ appetite for these stocks over the summer.”

Meanwhile, the theme of global growth has worked against domestically focused cyclical stocks.

“By contrast, the performance of small-cap value stocks in the US, which tend to be more cyclical and more geared to the US domestic economy, had lagged large-cap growth stocks by almost 20 percentage points by the beginning of September,” Knutzen asserted. “This is just the most extreme expression of the general lack of favor shown to the more cyclical parts of the economy.”

The lack of inflationary pressures mounting despite strong global growth is another key puzzle of the new market environment.

“Despite the synchronized growth cycle, the summer months saw inflation go missing in action across many of the world’s economies,” Knutzen wrote. “In the US, consumer prices started to disappoint in March and wage inflation has flatlined for a year.”

Whether the lack of inflation is structural or cyclical is a major point of debate for market participants and policy makers.

On the structural side, technology and demographics are seen as major deflationary forces. The competition and price pressures technology introduces are seen as rising costs. And a retiring population is seen as spending less, while creating demand for fixed-income assets that keep bond prices in check.

“Federal Reserve Chair Janet Yellen has expressed puzzlement, unable to decide whether this was a result of short-term effects or something structural, such as the rise of online shopping or the baby-boomer cohort entering retirement,” Knutzen wrote, and the Fed has consequently pushed out its schedule for interest rate hikes. This led to a cascade effect, with markets further discounting the prospect of rate hikes. “September saw Federal Open Market Committee (FOMC) members lower their ‘dot plot’ forecasts for the path of interest rates. But where the FOMC was merely hesitant, the market reacted strongly, lowering its estimate for the pace of 2018 hikes and, at one point, almost discounting a December hike altogether.”

For all the vexing about the lack of inflation in the new market backdrop, though, Knutzen argues that inflationary pressures are not structurally different, but just lagging.

“Our view is that we are currently moving from mid-cycle to late-cycle growth, which implies that some rise in inflation ought to be baked into expectations,” Knutzen wrote. “Against a background of synchronized growth, low and falling unemployment, and US corporate margins at record highs, we believe the current softness in inflation could be a lagged effect of weak growth and low energy prices during 2015-2016.”

The unduly disinflationary expectations subsequently create opportunities for investors, and more recent market actions show that initial perceptions could be changing.

September saw more inflationary expectations creeping into the market as “the US dollar and crude oil rallied, yields rose, energy and financial stocks were bid up, and rates markets pared back much of their skepticism about a December hike from the Fed,” Knutzen wrote. “But we believe that pricing still lags the potential, especially in key indicators such as US inflation break-even rates. As such, in a scenario of a return to a moderate rise in inflation, the Fed’s forecast for rate hikes in 2018 would be closer to reality than the markets.”

Whether and when inflation materializes, and gauging the role it will play, will be central to the new market environment and a break for the deflationary conditions of the last decade.

As the global economy demonstrates robust growth, meanwhile, central banks have begun to unwind their positions. And this means that investors must rethink paradigms from the post-financial crisis era, including the active versus passive debate, with the latter having made enormous strides in a high-correlation, low-dispersion era.

Art by JooHee Yoon

“Fueled by extraordinary global central bank intervention, equity markets have soared since their 2009 trough, leading to conditions unsupportive of traditional capitalism and active management, including high levels of correlation and low levels of dispersion,” Joseph Amato, Peter D’Onofrio, and Alessandra Rago from Neuberger Berman wrote in an October research report. “Stock correlations within the S&P 500, for example, have spiked nearly 20% since May 2009, depriving active managers of the opportunity to distinguish winners from losers through fundamental research. Post-crisis market conditions also suggest that the past decade is not an ideal timeframe over which to gauge an investment’s potential for long-term success across market cycles. We think central bank policy normalization could inspire a normalization in market dynamics.”

A result of the massive central bank interventions following the financial crisis changed how the market valued stocks.

“By reducing the cost of capital to near zero, Fed stimulus made risk assets more attractive on a relative basis and distorted equity market dynamics—including correlation and dispersion—that allow managers to distinguish among stocks through fundamental research. Correlation measures the degree to which stocks move in relation to one another, while dispersion tracks the magnitude of relative performance,” Amato, D’Onofrio, and Rago wrote. “Low correlation (an abundance of stocks whose movements are not closely aligned) and high dispersion (wide differences between the best- and worst-performing stocks within an index) afford greater opportunity for fundamental active management to identify winners from losers. Trends in these metrics since the financial crisis have favored passive.”

As central banks unwind stimulus, stocks may again be more heavily weighted on fundamentals. The tide that favored passive investing may be turning.

Asset owners have to navigate nosebleed valuations even as the market backdrop changes dramatically in 2018. The sustainability of synchronized global growth, the questionable role that inflation will play, and the value of picking individual stocks as correlations recede and dispersions rise will take center stage in the year ahead. The only thing certain about 2018 is that it promises to be a departure from the past.