Trophic Cascade
Science in school is so much more fascinating than I ever remembered it to be. Or perhaps I'm just a late bloomer when it comes to intellectual curiosity. I recently learnt about the mechanism of Trophic Cascade from my kids' sixth grade science curriculum. The documentary above explaining how the introduction of wolves saved Yellowstone National Park illustrates this concept lucidly.
Akin to introduction of wolves in Yellowstone, major regime shifts often find their origin in what might seem like a minor shift in direction at that point in time but it influences behavior changes that over time alter the course of history significantly. When it comes to monetary policy, Ben Bernanke's seminal speech on November 21, 2002 - "Deflation, Making Sure It Doesn't Happen Here"* definitely ranks as one of those. While the deflation fears post the bursting of the Nasdaq bubble and horrific terror attack of September 11 never quite materialized, Bernanke's speech became the policy playbook for global central banks in response to the recession caused by the Lehman bankruptcy in 2008. There were similarities to the experience of Japan over the decades prior and the risk of deflation rose materially mainly driven by -
Impaired Balance Sheets - The crash of the housing market had a catastrophic impact on the balance sheets of consumers and banks which required government intervention in the form of TARP to prevent a cascade of bank defaults and stabilize the financial system.
Negative Wealth Effect - The declines in equities and in housing prices was one of the largest post-WW2 destruction of household wealth which shifted consumer's attitude to spending somewhat but more importantly to credit and leverage.
Fiscal Austerity - Although the initial response to GFC was combination of fiscal and monetary, the attitudes towards expansionary fiscal policy shifted in the years following 2008. The shift was most pronounced in Europe where fiscal austerity became the policy mantra to counter deterioration in sovereign credit spreads of peripheral countries.
The Fed led by Bernanke, determined to prevent deflation, embarked on a series of policies including cutting rates to zero and multiple rounds of quantitative easing. The policies supported an abundant liquidity environment with low levels of real rates to cushion the economic impact of de-leveraging of private sector balance sheets. QE worked via the portfolio balance channel compressing risk premiums and suppressing volatility across rates, equities and credit. The threat of any negative shock to financial conditions elevating recession and deflation risks made the 'Fed Put' on equities and credit omnipotent. The introduction of the QE wolf in the ecosystem altered investor and corporate behavior and corporate buybacks, passive indexing, risk parity and other investment strategies which leveraged the 'Fed Put' increased massively in their size. The Fed's vigilance to fight deflation risks via unconventional policies influenced behavioral shift that truncated the downside tail and expanded the upside tail in equities and credit returns and valuations.
In contrast to the GFC, the nature of the Covid shock and the speed, magnitude and coordination of monetary and fiscal policy response was dramatically different. A year post-Covid, the factors that created an elevated risk of deflation post-GFC were in a very different place -
Strong Balance Sheets - The income support via direct fiscal transfers, the elimination of credit risk for SME via PPP and lending to directly impacted industries significantly truncated the credit loss tail at a consumer, SME, corporate and bank level. In addition, the large fiscal transfer, reduced mobility and solid labor income has boosted savings across consumers fortifying their balance sheets.
Positive Wealth Effect - Direct fiscal transfers, home appreciation, strong equity market returns and solid labor income has resulted in broad-based wealth increases that has supported consumption even as real wages have been negative.
Fiscal Stimulus - Apart from the large direct fiscal transfers which ensured that income actually increased even through the recession caused by the pandemic, the support for SME and corporates ensured that the recovery in the labor market was swift once the Covid risks receded.
The end result was an overheating economy constrained by supply leading to inflation realizing well above even the most aggressive expectations. The response from most central banks has been delayed but forceful. Despite supply constraints and war in Ukraine contributing to the elevated inflation prints, the Fed has made it crystal clear that the buck stops with them when it comes to inflation and bringing inflation back to its 2% target is unconditional. In contrast to the Fed post-GFC, the Fed (and other central banks) are now focused on truncating the tail of higher inflation after over a decade of fighting the deflation tail. This is a monumental shift that has significant implications for asset prices. To sustainably truncate the higher than target inflation tail of the distribution, real rates will and real cost of capital will need to move and stay higher for a period of time. This is a mirror opposite of the environment that existed post-GFC and the investor and corporate behavior will shift and strategies that relied on 'Fed Put' will no longer prove to be as attractive. The downside tail has to be fatter and upside tail truncated in equities and credit returns and valuations - at least until the inflation convincingly and sustainably moves back into the comfort zone. To put the inflation genie back in the bottle, in addition to supply chains normalizing, the three factors i.e. balance sheets, wealth and fiscal policy, will need to change sufficiently to become drags on inflation again.
In summary, the regime shift in Fed focus on truncating higher inflation tail from a decade of fighting the deflation tail is massive and has broad-based investment implications - some of which might take a while to play out -
equities and credit should have a larger downside tail relative to upside and valuations over time will move well below those persisted in the QE era with risks to overshoot to the downside in stagflationary environments where the central banks are handcuffed
reversal of suppression of volatility and reliably negative correlations between bonds and equities which would lead to de-risking and capital outflows from 60/40 and risk parity portfolios
decline in Sharpe ratio of passive beta strategies diverting capital to active alpha strategies
departure from abundant liquidity environment will increase liquidity risk premium impacting private equity / private credit strategies
These shifts will take time to crystallize and there is still a reasonable probability that the end of this cycle results in sufficient wealth destruction and balance sheet deterioration which coupled with a split government resulting in fiscal impasse puts us back into the pre-Covid world where deflation fighting becomes priority again. But as of now, the QE wolves are being pulled out and the impact of that will certainly reverberate through the ecosystem.
* https://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm