The Great Moderation Is Over | Liz Ann Sonders on What Replaces It

Episode Summary

Executive Summary: Lizanne Saunders argues 2026 is defined by instability rather than mere uncertainty: policy, inflation, labor, and markets are all bifurcated into K-shaped winners and losers. She expects continued broadening beyond megacap tech, more inflation volatility around a higher 2%-3% range, a more mixed Fed backdrop, and a labor market shaped by weak hiring, low firing, immigration shifts, and AI-driven task replacement.

Main Topics: Instability and the K-shaped economy (Priority: 5/5): Saunders distinguishes instability from uncertainty and says it is showing up across policy, geopolitics, consumers, inflation, labor, and markets, producing persistent bifurcation between winners and losers. Broadening market leadership and diversification (Priority: 5/5): She believes the late-2025 broadening trade has legs, with support for equal-weight, small caps, and international equities, though leadership will remain choppy and concentrated names may still see periodic rebounds. Inflation regime shift and the Fed (Priority: 5/5): She argues the U.S. may be in a higher-volatility inflation era where 2% becomes a floor rather than a ceiling, complicating monetary policy and likely keeping bond-stock relationships less stable. Labor market crosscurrents and data quality (Priority: 4/5): The labor market shows low firing but weak hiring, while immigration compression and lower survey response rates make official data noisier and increase the importance of alternative data sources. AI, capex, and productivity (Priority: 4/5): AI is viewed as a task-replacement tool rather than an occupation destroyer, with the AI boom moving from creation to buildout to broader cultivation across industries, supporting productivity and margins. Sentiment vs. hard data (Priority: 4/5): Consumer and investor sentiment remain weak even as hard economic and market data are better, due to negative news flow, labor anxiety, and a disconnect between what people say and what they do. Valuation, earnings, and factor investing (Priority: 4/5): She sees valuations as a poor timing tool and favors factor-based investing—especially GARP, positive revisions, margin stability, and balance-sheet strength—over monolithic sector calls.

Key Arguments: Instability in policy and geopolitics, not just generic uncertainty, is driving the cycle’s unusual bifurcation and K-shaped outcomes. The broadening out in equities should persist, but not linearly; investors should expect rotations, not a straight path. Small-cap rallies have been accompanied by lower-quality behavior, so she would avoid unprofitable small-cap names and prefer profitability. Inflation is likely to remain more volatile than in the Great Moderation, making 2% a practical floor rather than a hard anchor. The Fed faces a dual-mandate tug-of-war and is likely to remain in a fits-and-starts mode rather than a clear easing or tightening path. Official data is less reliable because of lower survey response rates, more imputation, and disruption from the government shutdown, so alternative data matters more. AI is currently more about automating tasks than eliminating whole occupations, especially through large language models handling grunt work. Labor force compression from weak immigration reduces labor supply and complicates comparisons, while productivity becomes more important for growth. Sentiment can stay depressed even when hard data is healthy because social/media negativity and labor insecurity shape perceptions. Earnings growth still matters, but direction of travel matters more than absolute levels; market leadership is shifting as megacap earnings growth decelerates and the rest of the market improves. Valuation alone is not a reliable market-timing tool; investors should focus on factors, earnings revisions, margins, and balance-sheet quality across sectors.

Data Points: Fed inflation target: 2% - Saunders says 2% may now function more like a floor than a ceiling in the inflation range. Inflation comfort zone: 2% to 3% - She suggests markets and the economy can probably handle inflation settling in this range. Great Moderation period: mid-1990s to early pandemic - Used as the benchmark era of low, stable inflation and a more predictable stock-bond relationship. Temperamental era: mid-1960s to mid-1990s - Her framework for a more volatile inflation and growth backdrop similar to today, though not a 1970s replay. Unemployment claims: initial claims remain incredibly low - Evidence of low firing, which she views as a labor-market tailwind. Survey response rates: significantly lower - BLS and other survey-based economic data are less reliable due to declining participation. Government shutdown: data desert - The shutdown reduced official data availability and raised the importance of alternative measures. AAII bearishness: record high percentage of bears in June 2022 - She cites this as an extreme example of sentiment diverging from portfolio positioning. AAII equity exposure: 1% off an all-time high - At the same time as record bearish sentiment, members still held near-record equity exposure. Retail trader volume: a third plus of trading volume on any given day or week - She says pandemic-era retail traders can dominate short-term market behavior. Russell 2000 composition: unprofitable stocks outperformed profitable stocks over the past year - Used to support her caution against lower-quality small-cap exposure. S&P 500 average member drawdown in 2025: negative 27% - Illustrates how broad market gains masked significant individual stock volatility via rotation. Nasdaq average member drawdown in 2025: negative 52% - Shows even strong index performance can hide severe underlying dispersion. Mag 7 free cash flow growth: from more than 60% y/y to slightly negative for three straight quarters - Supports her view that megacap earnings momentum has decelerated, aiding broadening.

Pivotal Quotes: "2% as the floor in the range" — Lizanne Saunders: Describing why the post-Great Moderation inflation backdrop is different from the past. "AI is a replacement of tasks, not really a replacement of occupations" — Lizanne Saunders: Explaining why AI is affecting hiring and productivity without implying mass job destruction yet. "the stock market is not a place for certainty. It's a world of probabilities and not predictions" — Marty Zweig (referenced by host): Framing the episode’s approach to market analysis and uncertainty.

Implications: Listeners should expect more rotation, less policy clarity, and a higher-variance macro backdrop. Portfolio construction favors diversification, factor discipline, and quality over concentration, while AI and broad earnings growth may keep market breadth improving underneath ongoing volatility.