Is the Next Temperamental Era Upon Us?

Excluding the 2007–2009 global financial crisis, the roughly 30-year period that preceded the 2020 pandemic was about as good as it gets for U.S. investors. During that time, which is called the Great Moderation Era, we enjoyed a decrease in the rate of inflation, fewer recessions, and lower economic volatility relative to the prior three decades. At the same time, globalization provided companies with cheap and abundant labor, elevating corporate profits as a percentage of gross domestic product (GDP).

Since the pandemic, however, we've seen an uptick in volatility across many economic and inflation readings, as well as more uncertainty and trade risk on the geopolitical front. We've also seen an increase in labor's power, with wages accounting for a rising share of GDP.

All told, the current environment bears a striking resemblance to the period from the mid-1960s through the early 1990s, which I've dubbed the Temperamental Era. If the comparison holds and we are indeed in a prolonged cycle of macroeconomic choppiness, it could have significant implications for investors.

If we're to understand the possible sequel, it's important to scrutinize two key characteristics that defined the Temperamental Era:

The Temperamental Era exhibited more robust growth during periods of economic expansion, but with higher highs and lower lows in GDP growth—and more frequent recessions. Since the pandemic erupted, we've seen similar economic behavior, with the year-over-year change in real GDP swinging from –7.5% in mid-2020 to nearly 12% in mid-2021 to around 5% in 2022.

Another defining characteristic of the Temperamental Era was heightened inflation volatility. The period was punctuated by two extreme peaks during the mid- to late-1970s, exacerbated by the Federal Reserve declaring victory on inflation too early. In both cases, the Fed eased policy only to see inflation creep up again. The aggressive rate hikes that followed hit the economy hard, generating back-to-back recessions in the early 1980s.

Today, the Fed is easing its interest rate policy as inflation pressures recede and the labor market weakens. We continue to believe that the latest trend of disinflation will hold, but there could be more inflation volatility going forward—for two principal reasons:

1. The supply shocks caused by the pandemic prompted companies to shift their inventory management from a global to a more diversified or regional approach. Although this can improve delivery timelines, regional supply chains may have limited capacity, which can drive up prices due to scarcity or higher production costs. 
2. The reemergence of big rivalries between the United States and China, and NATO and Russia, is raising the odds of more trade restrictions (like tariffs) and other supply risks.

The epic decline in interest rates that followed the global financial crisis created a tailwind that benefited both strong and weak companies. With borrowing rates near record lows for much of that period, "zombie companies" with no profits and insufficient cash flows to pay interest on their debt were able to skate by. However, if higher economic and inflation volatility is upon us, investors will likely need to be more selective, opting for stocks with strong fundamentals over those subsisting on hype alone.

• For fund investors, that might mean favoring actively managed funds—particularly those with a strong focus on fundamentals.
• For single-stock investors, focusing on fundamental factors like earnings per share, free cash flow, and return on equity can help identify strong balance sheets and a propensity for growth (for more, see "X factors").
• For all investors, regularly rebalancing may become increasingly important as economic volatility disproportionately affects various corners of the market.

Given some similarities between today's economic environment and the Temperamental Era, I want to underscore the importance of due diligence. Although there may be more frequent contractions, it may also mean the return of more robust expansions. In other words, there tend to be opportunities to further your financial goals—for those willing to put in the work.