A month and a half ago, we discussed how the Goldilocks narrative, which appears to have been the dominant investment paradigm in recent months, could be under threat from mounting evidence of domestically generated inflationary pressure. The risk to Goldilocks remains but the nature of the threat has changed.
Recall that we define Goldilocks as an unusual set of circumstances that are neither too hot nor too cold but just right for risk assets: robust synchronised growth but only modest inflation, a loose money/tight fiscal policy mix and no nasty surprises on the political front. These conditions help deliver low risk premia and a low risk-free rate which together combine to produce a low discount rate on the flow of risky returns that investors hope to receive in the future – or in short, higher valuations for risk assets.
We continue to believe that those valuations could come under pressure if inflation becomes ‘too hot’ for Goldilocks. Higher inflation would prompt a shift in monetary strategy, forcing a correction in the risk-free discount rate that would weigh on valuations unless that inflationary pressure is generated by greater pricing power in the corporate sector and wider margins that boost earnings. However, we have always been more concerned about what happens if we exit Goldilocks because the economy becomes too cold rather than too hot.
If expectations cool about the growth outlook and investors become concerned that there is a reasonable possibility of a recession within their investment horizon then we should expect to see a broad-based correction in risk premia across asset classes, given a higher probability that the flow of returns on those assets will be impaired and the issuer may even default.
In a normal business cycle, that potentially sharp correction in risk premia would be compensated at least somewhat by a shift in the monetary stance that would engineer a lower risk-free curve. Lower risk-free rates and significantly higher risk premia would deliver a somewhat higher discount rate. However, with many central banks close to the lower bound on official interest rates and in some cases close to the upper bound on asset purchases too, there is relatively little scope for many of them to provide additional support to the economy in a downturn. It is therefore of no great surprise that in the last major panic to roil financial markets – in early 2016 – concerns around the lack of monetary policy ammunition acted as an accelerant, helping to drive valuations sharply lower.
The data in recent months has been increasingly challenging the key foundation of the Goldilocks narrative: the synchronised global upswing. In our earlier piece we were still comfortable reporting that “growth still looks reasonably good” but the data has continued to slip since then.
Focus for a second on the eurozone, where the improvement in the survey data on activity, such as the Purchasing Managers Index (or PMI), had been most apparent in late 2017. Since the turn of the year the eurozone PMI has been quietly deflating – from 58.8 in January to a flash estimate of 54.1 in May. Other key indicators like the ifo business climate index tell a similar story. The hard data on activity produced by the national statisticians is somewhat harder to read, because it is more likely to be heavily distorted by erratic factors such as bad weather. Nonetheless, there is still the impression that the underlying pace of growth has moderated somewhat. The data surprise indicators suggest that investors had not been expecting this turn of events, with a marked turnaround from the data consistently coming in above expectations at the start of the year to more or less the opposite phenomenon more recently.
Chart: Eurozone composite PMIs, flash estimates where available
Source: Haver, April 2018
Nor is this a uniquely European phenomenon. There has been a marked loss of momentum in the Japanese economy, which actually contracted in the first quarter. There is some tentative evidence from the global trade data of a slowdown in the Asian export engine, but that is probably better described at this juncture as simply a reversion to trend rather than anything more worrisome. The one clear stand-out performer appears to be the United States, where the activity indicators are still holding up.
Chart: PMIs, flash estimates where available
North Asia 3 = South Korea, Taiwan and Singapore;* Ex-oil exports for Singapore
Source: Haver, May 2018
So is time up for Goldilocks? We don’t believe so, or at least not just yet – although we are much closer to our line in the sand on whether the economy is becoming too cold. That weaker survey data needs to be put into proper context. First, it is not a flawless indicator of the hard data on GDP that we really care about. And, second, the PMIs have not yet sunk to significantly sub-trend – let alone recession – levels. Nevertheless, we do not expect investors to wait for confirmation in the hard data or for the soft data to fall to levels consistent with recession before they hit the panic button. And we will thus need to be a touch trigger-happy in our assessment too: Goldilocks is on notice.
The final question is how central banks would respond if the global economy does cool. As we explained above, many of them have precious little monetary ammunition left to fire. The European Central Bank could guide the market to price out what remains of the anticipated tightening cycle over the next few years with relative ease, but cutting rates further or ramping up sovereign bond purchases would be a much taller order. Unfortunately, there is relatively little fiscal wriggle space, too: relatively few governments have the capacity to inject a sizeable fiscal stimulus without re-awakening concerns about debt sustainability. It is for precisely these reasons that we believe that a too-cold exit from Goldilocks could all too easily morph into a positively polar scenario for risk assets.