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The Seeds of Higher Market Volatility Were Sown
Pioneer Investments
By Mike Temple
November 19, 2012


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A paradigm shift in financial markets has taken place since 2008 into a more volatile investment environment that will demand different ways of managing risk. In an ironic twist of intention, today’s higher volatility is the consequence of attempts by central banks to engineer a less volatile economic environment. This environment, one in which recessions are shorter/shallower and expansions stronger/ longer than they were in the early part of the 20th century, has its roots in the early 1980s and has spanned over two decades (read about it our “Blue” Paper titled, Living in a More Volatile Investment World.)

Dubbed “the Great Moderation” this period commenced with the resetting of inflation expectations by Fed Chairman Volker through his attempts to break the back of inflation by a focus on money supply. In addition, the trend toward globalization helped defuse inflationary influences (as overseas capacity robbed firms of pricing power, and were a “relief valve” for domestic price pressures). The decline in inflation and inflation volatility helped support a prolonged decline in interest rates.

The “Paradox of Credibility”

Improved corporate balance sheets, more transparent monetary policy, and new “riskdiversifying” financial instruments also lowered the perceived riskiness of investing in securities tied to economic growth. Unfortunately, the stable macroeconomic environment and strong central bank credibility created a false sense of security. Hyman Minsky dubbed this the “paradox of credibility.” The Great Moderation era led to excessive credit expansion and an underpricing of risk. Valuation bubbles and excess debt were the consequence, manifesting three times since the early 1990s in both the U.S. equity and two real-estate busts.

To combat the economic aftereffects of burst bubbles, the Federal Reserve (“Fed”) aggressively reduced interest rates (Fed Funds rate changes as they occurred, chart blue line). But because of increasing systematic leverage (measured by government debt to GDP, reported quarterly, red line), rates had to be lowered further in each cycle, kept lower for longer, and raised less each time before the economy tipped back into recession.

This graph shows the increase in leverage and the path of lower highs and lower lowsin interest rates. The story in Europe and Japan is similar.

If central banks in the developed world are becoming less effective stewards of the business, interest rate and credit cycles, it is likely we are going to experience more frequent economic volatility; more “soft patches,” shorter and less robust expansions and prolonged recessions.

 

(c) Pioneer Investments

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