Falling volatility signals sustainable global rebound for leading economies
Increasing signs of stability in advanced countries, across economic and market indicators, are taken by some as a return to the Great Moderation
Barely five years after the worst financial turmoil and recession since the Great Depression, the United States and fellow advanced nations are showing a stability in output growth and hiring last witnessed in the two decades prior to the crisis, in an era dubbed the "Great Moderation". The lull points to a worldwide economic expansion that will endure longer than most.
Volatility in growth among the main industrial countries is the lowest since 2007 and half that of the 20 years starting in 1987, according to calculations based on International Monetary Fund data.
Investors also are becalmed, with a risk measure that uses options to forecast fluctuations in equities, currencies, commodities and bonds around the weakest level in almost seven years.
"That's why I call it the Great Moderation 2.0," said John Normand, head of foreign exchange and international rates strategy at JP Morgan in London. "It looks, sounds and feels a whole lot like that last time we had reason to use that label."
Such calm finally is providing a support for equities over bonds and giving companies and consumers long-sought clarity to spend. This does not mean the scars from the slump have fully healed. Growth still is sub-par, and there is a threat investors will repeat the excessive risk-taking that turned past booms into busts.
The International Monetary Fund's latest forecasts suggest output volatility in the Group of Seven nations will ease to 0.4 per cent this year compared with almost 3 per cent in 2010 and a 0.8 per cent average in the two decades ending 2007. .
Variability in the growth of employment also has declined to 0.1 per cent this year; it tripled to 1.7 per cent in 2009, calculations for the labour market show.
Meanwhile trading has chilled: Bank of America's Market Risk Index closed at minus 1.14 on May 2, the lowest since June 2007. Fluctuations in the US$5.3 trillion-a-day currency market also are the lowest in about seven years, according to JP Morgan's Global FX Volatility Index.
"People are catching up to a return to a more normal environment in terms of market volatility and the economy," said Dominic Wilson, chief markets economist at Goldman Sachs in New York.
Professors James Stock at Harvard University and Mark Watson at Princeton University are credited with coining the phrase Great Moderation in 2002.
A decade later, Wilson's team is citing old and new trends in explaining why the world is returning to the relative calm it enjoyed before the crisis of 2008, which took down Lehman Brothers and global demand.
Goldman Sachs sees another explanation - stronger regulation of bank and consumer debt following the crisis means economic growth will be less amplified by easier lending than before.
Normand said the Great Moderation 2.0 still may not prove so great. For one thing, the market calm may not last the year, given the business cycle will mature and inflation concerns may emerge, he said.
The current lack of volatility also could feed complacency among investors, pushing them as it did before to take on more risk, which later proves foolhardy for them and the economy. Financial-stability concerns already are building within central banks, with April's 10.9 per cent jump in British property prices, as well as technology stocks and junk bonds in the US, among the assets drawing attention.
The latest lack of volatility also is occurring at a lower level of growth. The G7 economies expanded 2.6 per cent in the 1990s and 2.2 per cent in the first half of the 2000s, according to IMF data. Since 2009, growth has averaged 1.9 per cent.
If the calm does hold, then investors should be wary of holding too many Treasury bonds as growth gains momentum, said Neil Dutta, head of US economics at Renaissance Macro Research in New York.
In what he calls an "old normal" scenario, interest rates would rise gradually along with the economy, encouraging investors to seek out risky assets such as equities.
Dutta estimated in an April 21 report that the US economy is 57 months into its expansion, implying a further 38 months just to get back to the 95-month average upswing in the previous period of moderation.
The same outlook holds for the world economy, according to Joachim Fels, co-chief global economist at Morgan Stanley in London. He has identified six global expansions since 1970: 1970-1974, 1976-1979, 1983-1990, 1994-2000, 2002-2008 and since 2010. That is an average of 5.8 years.
Fels says the current pick-up will last because slow recoveries leave lots of room for hiring and investment to increase. Low inflation means monetary policy can stay easy, while the lack of a synchronised acceleration lowers the risk of a joint overheating.
"This global expansion could become the longest in post-war history," Fels said.