Financial markets abhor an equilibrium
THE recent volatility in the stockmarket has come as a shock in part because equities have been performing well for an extended period. Share prices have been on a broadly upward trend ever since the spring of 2009. That follows the long bull market of 1982 to 2000. As the chart shows (on a log scale), there has been a tendency for bull markets to be longer-lasting than they were in the 1960s or 1970s.
The same can be said for the economy. The average business cycle since the Second World War has lasted around six years. By that standard the current expansion is elderly, at eight-and-a-half years. But it still has a way to go to outlast the longest post-war cycle, the ten years from 1991 to 2001. Indeed, that cycle was followed by a very shallow recession. In a sense, there was a long boom from 1991 to 2007.
Given the shift from a manufacturing-dominated to a service-dominated economy, a longer cycle makes sense. The manufacturing sector has long lead times. Strong demand for cars or washing machines causes the manufacturer to order more commodities and components; perhaps to take on more staff. At the peak of the boom, this demand will push up prices and inflation will start to edge up. The central bank will respond by tightening monetary policy. At some stage, this will cause demand to slip and manufacturers will be left with surplus staff and inventories. They will abruptly cut their orders and lay off workers; suppliers and commodity producers will be forced to do the same. A rise in unemployment will cause demand to slip even further until the central bank cuts rates and the cycle can start again.
To an extent, the service sector is not subject to the same cyclical pressures. In part, this is because it has underlying growth behind it; it is taking a greater share of output. But it is also true that Microsoft does not need to stockpile software before it can sell it. So most services companies are less prone to an inventory cycle.
But I think the broader explanation of these longer cycles lies in monetary policy. Under the Bretton Woods system which lasted until the early 1970s, countries were obliged to peg their currencies to the dollar. If the trade deficit started to widen, then the central bank had to step on the monetary brakes; this was the stop-go cycle that bedevilled Britain. The one country that was not tied down by this system was America. In the 1960s, under Lyndon Johnson, America financed both the Vietnam War and social reforms. The country had an eight-year boom, from 1961 to 1969 but this eventually broke the Bretton Woods system. Markets then suffered an inflationary shock in the 1970s owing to floating exchange rates and the oil embargo.
Order was eventually restored by Paul Volcker at the turn of the 1980s. Both financial markets and the economy were then able to benefit from the steady decline in inflation and interest rates. But the length of the cycle should not disguise the enormous amount of change that was going on underneath the surface.
The feedback loop
When the market crashed in 2007 and 2008, the work of the economist Hyman Minsky enjoyed a revival. One can restate Minsky’s work as the principle that
Financial markets abhor an equilibrium
Investors try to analyse the economic and financial conditions and adjust their portfolios accordingly. Often there is a lot of disagreement. But sometimes there seems to be a consensus that a climate has been established and will continue. Think, for example of “stagflation” in the 1970s, the “great moderation” in the 1990s and the early 2000s or indeed “secular stagnation” in recent years. They adjust their portfolios and their behaviour accordingly and, crucially, the fiscal and monetary authorities respond to their actions.
So the bitter experience of bond investors in the 1970s led them to demand very high real bond yields to compensate them for the inflation risk. These high real yields in turn caused politicians to be cautious about running up fiscal deficits and to rely on monetary policy to manage the cycle. Falling rates boosted asset values, including equities and house prices, and made executives rich from share options. The potential rewards of equities helped fuel the dotcom boom. Two sectors that benefit from leverage, hedge funds and private equity, flourished as never before. Credit expanded and that credit was used to buy assets; rising asset prices persuaded lenders to extend more credit. All this was helped by developments in the real economy, as falling commodity prices and the addition of China and eastern Europe to the capitalist world, held down inflation.
Investors got carried away, first in tech-sector equities, and then, more seriously in mortgage-backed securities in the lead-up to 2007. When markets crashed, central banks were forced into drastic measures, cutting rates to zero (and below) and unleashing quantitative easing.
Financial markets then adjusted to this new equilibrium. They learned that rates and bond yields would stay low, while profits recovered sharply from the 2009 downturn; equities were the asset to hold. But a populist backlash emerged. There was a sense that the banks had escaped the consequences of their actions. And the strength of profits was down to the stagnation of real wages. The result was the electoral rebellions of 2016.
Being led by a billionaire, American populism has been good for the plutocrats. But the main policy response has been a big tax cut for the better-off. While this initially seemed good for the equity markets, doubts are starting to emerge. The general feeling of euphoria has emboldened central banks to talk about further tightening while the prospect of trillion-dollar budget deficits may require higher bond yields to tempt investors.
The long and the short of it
If this is a turning point towards a period of more “normal” rate levels, then the tendency to long cycles may not last. For the first time since the 1970s, the secular direction of rates and yields may be up, not down. That is a problem for those who borrow to buy assets. And it is also a problem that has even more debt, relative to GDP, than it did in 2007. After years of being encourage to borrow by shareholders and the tax system, the average corporate credit rating is much weaker than it was 20 or 30 years ago.
The new cycle may be based, not on the inventory cycle, but on the credit cycle. Even modest steps on the monetary brake may have quite rapid effects on markets and on the broader economy. The last week or so of volatility may reflect the fact that investors are waking up to this issue.