Upbeat markets turn the page on cautionary post-crisis regime

The Wall Street Journal recently cited a Morgan Stanley analysis demonstrating that correlations between asset classes have plunged to their lowest levels since 2006. Market movements as powerful as this are not always right, yet they are unbiased and have a good batting average.

The cryptic message behind this plunge is that the post-crisis period — or market “regime” — of stall-speed growth has ended and has segued into a new regime characterized by the reflation of growth, pricing, confidence, business investment, profits, interest rates, tax revenues, and the stock market. 

{mosads}Market regimes are periods characterized by persistent excesses or insufficiencies in either the supply or demand for goods, services, or capital (either financial or human). Usually these imbalances self-correct. When they don’t, we call them regimes.

The post-crisis regime (2009 to mid-2016) was characterized by excess supply of manufactured goods from China, insufficient global demand, and an excess of liquidity as central banks tried their best to combat these powerful forces. 

High asset-class correlations during the post-crisis regime reflected markets that were atypically focused on systemic risk. Growth was so slow that unexpected exogenous shocks could send the economy back into recession and outright deflation at a time when central banks — following years of accommodative monetary policy — were viewed as being out of ammunition.

That backdrop led to pervasive caution, with markets constantly on the lookout for the next disaster. Instead of the normal focus on the risks and opportunities of individual companies, countries, or asset classes, markets reacted in unison to false sightings of the next systemic risk. 

Two camps attempted to explain the slow growth. One focused on secular stagnation, arguing that populations were aging, productivity was sputtering, and economies would be slow for as far as the eye could see.

The other, articulated in 2009 by Carmen Reinhart and Kenneth Rogoff in, “This Time is Different: Eight Centuries of Financial Folly,” concluded that post-crisis periods were typically accompanied by private sector deleveraging, which caused slow growth until the deleveraging process ran its course. Post-crisis deleveraging tended to last 7-10 years, after which growth revived. 

Private sector leverage in the U.S. did drop substantially from 2009 through mid-2016. Regulatory burdens also rose sharply, differentiated by the severity with which “know thy client” regulatory burdens were mandated on the banks. Massive financial penalties were imposed, all while required capital levels were raised.

These regulations were so onerous that many banks had to walk away from their small and mid-size clients. This choked off growth from the small enterprise segment of the U.S. economy, which has historically supplied most of the jobs.

Some argue there was no loan demand to choke-off, but that doesn’t explain how a private credit industry emerged out of nowhere and mushroomed to fill the void left by banks. Fortunately, this wet blanket has now been lifted.

China was a first mover in finally and effectively addressing this deflationary backdrop. In early 2016, it took aggressive actions to reign in its excess supply and to stop exporting deflation. Right on cue, U.S. private sector deleveraging bottomed in 2016 and is now heading back up.

With re-leveraging comes the prospect of sustainably faster growth. As of mid-2016, nominal GDP, profits, and pricing power finally rose above stall speed and asset-class correlations began to decline. 

When the U.S. election subsequently brought forth the unexpected likelihood of regulatory rollback and fiscal expansion, small business optimism spiked and correlations plunged. Indeed, in the last several annual surveys of CEOs by PwC, “overregulation” was the most commonly cited concern. This had never been a top concern, pre-crisis, in the 20-year history of this survey.

The long awaited post-crisis stall speed economy ended, and the rotation away from defensive assets like fixed income toward offensive assets like equity has begun. Business fixed investment should step up imminently amid greater confidence and pricing power and a more business-friendly environment. This should help reverse poor productivity. 

During the pre-crisis market regime, high correlations between individual stocks (called pairwise correlations) made life difficult for active managers and added a shot of adrenaline to the exchange-traded fund (ETF) craze. The correlations translated into insufficient differentiation between the performance of stocks with favorable fundamentals and those with unfavorable fundamentals.

Investors who picked the winners did not get enough bang for their buck to offset fees and transaction costs. Now these pairwise correlations have also recently plunged. While the powerful trends behind ETFs will not go away, they are now due for a rest, with more favorable times immediately ahead for active management. 

Michael J. Kelly is the global head of multi-asset investment at PineBridge Investments and a frequent contributor to CNBC, Bloomberg, and other media sources.

The views expressed by contributors are their own and not the views of The Hill.