Secular stagnation: RIP
In our December outlook, we predicted possible surprises this year in inflation and volatility. Since these surprises came to fruition in February, we decided to interpret what they might mean for the rest of 2018.
The theory behind secular stagnation is that the economy grows very slowly, and as a result, inflation and bond yields stay contained. Within a few years, the economy potentially stumbles into a recession. Instead, strong economic numbers, the US tax bill, and positive consumer sentiment helped fuel an explosive stock market rally in January.
At the end of January, higher-than-expected payroll numbers and wage growth surprised investors. This raised the prospect of higher inflation, fueling concerns that the Federal Reserve (Fed) would tighten rates and create more headwinds for equities. The changed outlook helped cause stocks to tumble.
The positive labour report also caused the yield curve to steepen. Many investors started reversing that trade, triggering a significant sell-off in the bond market. This may have finally broken a 30-year trend of declining bond yields.
Simple panic selling and repositioning were likely the primary triggers of the sell-off. We believe investors’ short positions in VIX futures(1) amplified the effects of the sell-off. As the market traded lower, the VIX rose and short positions came under pressure. Investors had to close them out by buying them back, which drove VIX prices even higher.
The Euro Stoxx 50 Volatility Index (VSTOXX)(2) , another volatility index, is usually higher than the VIX. Interestingly, on 6 February, the intraday peak of the VSTOXX was only 32, while the VIX was 50.2 (3). This underscores, our belief that existing short positions in the VIX — and the need to cover them after the sell-off — placed upward pressure on the VIX, amplifying volatility.
The sell-off in equities drove the 12-month forward PE ratios down from over 19.0x to about 16.8x, making valuations somewhat more attractive. Meanwhile, we see little that would stop global economic momentum other than a sharp spike in real (versus nominal) interest rates, which could drive borrowing costs higher. We expect bond yields to climb above 3%. If they hit 3% and inflation rises to 2%, real yields will be around 1%. With real yields averaging 1.6% over the last 20 years, this is not high from a historical perspective.
If interest rates rise dramatically, real yields can change quickly. For now, in the absence of a sudden rise and without an uptick in inflation, we do not see real yields rising higher than 1.5%. Given that the Institute of Supply Management (ISM) data recently hit cyclical highs, it is unlikely that real yields in the 1.0-1.5% range would be enough to slow the economy down.
As expected, on 21 March the US Federal Reserve raised short-term rates by 25 bps, to 1.75%. In his first press conference as Fed chair, Jay Powell avoided saying anything that might spook markets; rather, his upbeat comments on US growth prospects simply confirmed our belief that we should expect a total of 4 hikes in 2018 and 3 in 2019.
As we predicted one year ago, higher wages, rising rates and accelerated growth are feeding inflationary pressure. The Fed itself is also a source of pressure, since it’s currently sitting on huge excess reserves that could flow into the U.S. economy. Inflation may surprise on the upside this year both in terms of Consumer Price Index (CPI) and wage increases. Both valuations and consumer sentiment may be at high levels, but with stable real yields, rising productivity and “normalised” valuations, the equity outlook is not necessarily negative — as long as economic growth continues.
The bigger risk, however, is for bonds. Aside from inflation-protected securities, bonds are priced in nominal yield rather than real yield terms. Even if real yields don’t rise — because inflation keeps pace with the rise in bond yields — regular bond prices will suffer if nominal yields rise.
The market correction in February confirmed our predictions about inflation and volatility. But we don’t see a reason to be overly concerned about equities, as long as the U.S. economy keeps churning along at its current pace, though there is greater risk for bonds. We don’t expect inflation to accelerate until next year. For the rest of 2018, we expect continued global economic growth and corporate earnings, and the end of secular stagnation.
 The Chicago Board of Exchange (CBOE) Volatility Index (VIX) measures expectations of 30-day volatility, based on the implied volatilities of a range of S&P 500 index options.
 VSTOXX Indices are based on EURO STOXX 50 real-time options prices and are designed to reflect the expectations of volatility.
 Source: Bloomberg.
Andrew Harmstone, is senior portfolio manager in the Global Multi-Asset team and heads the London-based Global Balanced Risk Control (GBaR) strategy at Morgan Stanley Investment Management