In a recent meeting of T. Rowe Price’s Asset Allocation Committee, a question was raised about whether we had entered a new market regime. The question is at once simple and complicated. So, I asked my colleague, Gerard Brunick, a quantitative analyst in the Multi-Asset Division, to crunch the data to see whether recent conditions in the financial markets might resemble past market regimes.
Some Conclusions First
1.We are likely in a new market regime.
2. Recent economic conditions do NOT look like the stagflation that occurred in the 1970s.
3. We shouldn’t get too bearish because, historically, markets showed plenty of life when the fed funds rate was above 5%, as it is now.
4. Higher interest rates don’t necessarily take all the oxygen out of the system. The market could get excited by the prospect of productivity gains driven by artificial intelligence (AI).
Four Historical Market Regimes
Looking at market history, we identified four distinct eras:
1. Postwar Boom (1955-1969)
Because of data limitations, our “postwar boom” started in 1955, a decade after the end of World War II. This era of prosperity had the strongest economic growth and the lowest unemployment of our four regimes. Inflation was also low, in the 2% range, and there were strong productivity gains.
2. Stagflation (1970-1981)
With stagflation, inflation spikes due to supply shocks, even when demand is weak. This era featured oil price shocks in 1973-74 and 1978-79. This regime began in 1970 and eventually ended after central bank Chair Paul Volcker slayed the inflation dragon by taking the fed funds rate as high as 20%. Stock returns were the lowest of the four regimes.
3. Old Normal (1982-2007)
The steady decline in interest rates was the defining feature of this era. Economic growth and inflation were “normal,” at about 3% each per year. Capital markets outperformed the economy due to rising valuations and cheap leverage. The business cycle continued, with bull markets and crashes.
4. New Normal (2008-2019)
After the global financial crisis, we entered an era of extremely accommodative central bank policy. The economy got stuck in neutral, with low rates, low growth, and low inflation.
"The world is different now.We’re in a new regime, an environment that will look different from what we studied."
What About Now?
So, the questions become, what historical market regimes rhyme with the recent environment and can those regimes be instructive for what might be to come? When you look at the most recent Fed funds rate and inflation readings, today is closest to the Old Normal. Interestingly, the second-closest historical regime is the Postwar Boom. When you add a third factor, GDP growth, the current environment still looks closer to the Old Normal, even though the relatively low rate of economic expansion is more in line with New Normal standards. Adding unemployment as a fourth factor makes the Postwar Boom look most like today’s environment.
My View from the Knife’s Edge
Over the short term, the market could shift into something resembling any of the four historical regimes. However, a return to the New Normal strikes me as the least likely outcome. The New Normal is old news. Stagflation also appears less likely. In our analysis, current conditions call most likely for a split between the Old Normal and the Postwar Boom. But if inflation reaccelerates above 6% and economic growth remains anemic, the likelihood of a return to stagflation would increase significantly.
Our Asset Allocation Committee believes that inflation risk skews to the upside. Rising energy prices are a concern amid emerging pressures on supplies. Labor costs may also head higher, a point underscored by the United Auto Workers strike. High interest rates won’t kill the economy. Current rates are high relative to the New Normal, but not relative to history in the capital markets. The Fed funds rate has exceeded 5% for decades, and stock markets still did well.
The world is different now. We’re in a new regime, an environment that will look different from the four we studied. Nonetheless, history often rhymes with the present. So, let’s not get too bearish. Market segments that don’t trade at nosebleed valuations, such as small- and mid-cap stocks and real asset equities, look appealing on a relative basis. And if we see a spike in volatility and a market sell-off, it may be an opportunity to buy stocks.
