Why Volatility Is The New Normal: From Great Moderation To 'Temperamental Era'

For over 30 years before the COVID-19 pandemic, investors thrived during what is often referred to as the Great Moderation. Despite a painful episode with the Great Recession, this period saw relatively stable economic conditions, with fewer recessions, lower inflation, and diminished volatility.

The rise of globalization and free trade during this era provided corporations access to cheaper labor and production resources, bolstering profits and encouraging growth. However, according to Liz Ann Sonders, chief investment strategist at Charles Schwab, this stability era has ended. Sonders has coined the current phase the ‘Temperamental Era,’ a period she likens to the volatile economic landscape of the mid-1960s through the early 1990s.

Sonders sees this era as one with increased volatility in economic performance and inflation. Since 2020, dramatic swings in GDP growth have become commonplace, with sharp contractions followed by rapid rebounds—similar to the patterns seen in the latter half of the 20^th century.

Inflation has also become more volatile, reminding economists of the 1970s. Back then, the Federal Reserve declared victory over inflation prematurely, leading to policy missteps and back-to-back recessions in the early 1980s. Sonders notes that the current environment is similarly characterized by uncertainty in inflation trends, accompanied by ongoing supply chain reconfigurations and geopolitical tensions.

As companies move toward nearshoring or regional diversification, they drive a shift in supply chain management. Although this strategy enhances resilience, it also raises production costs due to limited regional capacities. Meanwhile, the re-emergence of geopolitical rivalries, particularly between the U.S. and China, and NATO and Russia, causes tensions, increasing the likelihood of trade restrictions, tariffs, and supply risks, further fueling inflationary pressures.

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ING's research last year found that while a repeat of the 1970s inflationary crisis is not inevitable, the risks of higher and more volatile inflation and central bank rates over the next decade are significant.

Shortages of key materials, partly driven by the green energy transition and geopolitical conflicts, could exert upward pressure on prices. Additionally, worker power gradually increases due to labor shortages, pushing wages upward. Accompanied by tighter fiscal and monetary policies designed to curb inflation, the environment limits the flexibility of governments and central banks to respond to future crises.

For investors, this new era demands a shift in strategy. The low-interest-rate environment of the Great Moderation enabled even weak companies to survive on cheap borrowing, but that era is over. Instead, Charles Schwab sees the importance of focusing on fundamentals when selecting stocks.

They note price-to-cash flow, price momentum, and return volatility as metrics of interest. Price-to-cash flow helps investors gauge a company's ability to sustain operations and meet financial obligations. Price momentum identifies stocks with favorable trends, as past performance often predicts short-term direction. Lastly, return volatility (Beta) measures the stability of a stock's price movements, with lower volatility typically signaling a less risky investment.

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Image created using artificial intelligence via Midjourney.