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In the first couple of years after the financial crisis, there was a lot of discussion about the “new normal.” This referred to the new environment characterized by lower interest rates, lower growth, lower inflation, and lower volatility. The sense was that things really were different this time, and we had to understand that.
Now, I would argue that we are entering another phase change in the global economy: moving from the new normal after the crisis to the “new new normal.” In some respects, this new new normal will bear a significant resemblance to the old normal, pre-financial crisis.
What does this mean?
This means we are moving back to higher interest rates and higher volatility. It remains to be seen whether it also means higher inflation, as well as how it will impact growth. In short, the new new normal will apply mainly to the financial world—but not necessarily to the real economy.
From the crisis to now, the connection between the real economy and the financial economy has been fairly direct. Central bank policy largely drove real economic activity, which in turn drove financial markets. That was the story from 2009 through 2017, at which point that process culminated with all major central banks using monetary policy for stimulus. The decision by the Fed to start reducing its balance sheet and start raising rates signaled the end of this stage, as well as the start of the next.
The real economy
In this next stage, we can expect to have the real economy continue to grow organically. But that growth is likely to slow as monetary stimulus slowly goes away. Here in the U.S., that will be mitigated by recent fiscal actions, including the tax cuts and increased government spending. But the drag will be real. Abroad, while central banks have not yet pulled back, expectations are increasing that they will. That changed perception will also act as a drag, although a smaller one. Growth can therefore be expected to slow somewhat in the new new normal.
The financial economy
For the financial economy, the effects will be more complex. For most of the past five-plus years, markets have risen largely along with the fundamentals. Recently, however, the two have decoupled and market valuations have risen even faster. Slower growth, coupled with the larger gap between valuations and the real economy, will increase the pressure on the financial economy. Higher interest rates on top of this will result in increased volatility.
This is exactly what we have seen so far this year—slower growth, higher rates, and much higher volatility. With these base conditions in place, and the likelihood that rates are going to continue to move higher, we can reasonably expect volatility to stay high. This is the new new normal.
Back to reality?
As investors, the year-to-date has been a bit of a shock, especially after the calm of 2017. We have gotten used to calm and rising markets, created largely by a calm real economy and supported by central bank action. As the central banks start to pull back, markets are moving back to reality—and are likely to keep doing so.
Bottom line? The new new normal is likely to be just that—normal. It’s time to get used to it because it will likely be with us for a while.
