Beware the risks of a fragile Goldilocks

07 May 2019

While markets continue to price in a Goldilocks setting, a global slowdown or the US economy overheating, leading the Fed to resume tightening, could expose just how fragile this environment is.

  • Goldilocks firmly in place – More stable, but generally moderate, growth, contained inflation and dovish central banks underpin this environment
  • But this remains a ‘fragile’ Goldilocks – Disruption could come from a global economic slowdown and an overheating US economy forcing the central bank to tighten policy
  • Asset markets currently do not reflect this fragility – Equities are up by roughly 15% so far this year, while the 10-year US Treasury bond yield is close to 20bp lower
  • The US economy is still a bright spot – More stable US growth looks more certain than the tentative European or Chinese stabilisation.

Exhibit 1: April 2019 vs. Q1 returns – equities and oil rally again

q1-returns-equities-and-oil-rally-again

Source: Bloomberg and BNPP AM, as of 30/04/2019

 

Goldilocks firmly in place

Markets are firmly pricing in a Goldilocks environment: solid, but unspectacular US growth combined with moderate core inflation are reassuring investors that the Federal Reserve’s dovish policy turn can be sustained for some time (Exhibit 2).

Exhibit 2: US growth and core inflation endorse Goldilocks

us-growth-and-core-inflation-endorse-goldilocks

Source: Bloomberg and BNPP AM, as of 30/04/2019

The Fed has acknowledged that it sees few inflationary pressures and has hinted that it will be more tolerant of inflation. Indeed, this is consistent with a potential change in its policy framework towards one where policy rates may need to be lower for longer to ensure that the central bank hits its inflation target on average over time.

Financial markets have continued to behave in line with the idea of Goldilocks. Equities gained in April and fixed income markets were stable, after strong returns across all assets in Q1. This suggests that investors are seeing signs of growth stabilising. However, they are yet to be convinced fully that stabilisation is here to stay. Indeed, market expectations for Fed policy by the end of 2019 continue to price in rate cuts, suggesting that markets still see risks to growth.

 

But it remains a ‘fragile’ Goldilocks

We believe the Goldilocks setting engineered by the Fed and other major central banks is ‘fragile’ for various reasons. Firstly, the global cycle is now more advanced than in previous periods when the Fed paused its tightening policy, notably after the growth scare of 2016. That means further Fed tightening or negative shocks such as a renewed slowdown in China or Europe could tip the balance of the recovery, triggering a deeper slowdown or potentially a recession.

Secondly, despite any growth concerns, the US economy is expanding and the labour market continues to tighten. This is now visible in rising wage pressures. So far, the pressures have not pushed core inflation higher. Yet, the overheating risk is still real, especially if higher oil prices contaminate inflation expectations and if the US economy continues to grow at above potential.

Exhibit 3 illustrates the fragility. The Fed pause has pushed markets firmly into the upper left hand quadrant, but we believe the risks of sliding towards a synchronised global slowdown (bottom left) or to an overheating US economy (top right) remain alive and real.

Exhibit 3: Cycle and Fed policy – scenario analysis

cycle-and-fed-policy-scenario-analysis

Source: BNPP AM, as of 30/04/2019

 

Is Goldilocks already priced in?

One of the most heated debates among market participants is whether Goldilocks has already been priced in. In other words, do the rally in global equities and the fall in UST 10-year yields since the beginning of the year capture the Fed’s pivot and the economic fundamentals? We see reasons for being cautious about chasing these market moves.

They include the typical asset price moves around the end of Fed tightening cycles, equity valuations versus those of bonds, the risk of a market melt-up as cautious participants are sucked into the rally, and the possibility of further positive news on the economic fundamentals and company earnings.

As for asset valuations, since the mid-1980s, end-cycle pauses have generally been associated with equity rallies. US Treasuries have generally risen during pauses and continued to do so as the Fed cut rates. This year’s sharp equity gains suggest caution when considering whether to chase the rally.

 

Exhibit 4: US equities and UST bonds generally do well during Fed pauses*

(total annualised returns, in %)

us-equities-and-ust-bonds-generally-do-well-during-fed-pauses

*Measured from the last Fed rate rise in the cycle to the first cut. The current episode is from the December 2018 rate rise to now. Source: Bloomberg and BNPP AM, as of 30/04/2019

 

Comparing real yields, UST and equity yields (measured as trailing earnings over price) fell sharply after the global financial crisis, but at this point, equities no longer look materially more attractive than bonds in terms of yield.

One of the main bullish arguments is that the recent rally has not enjoyed broad investor participation. So, investors could be sucked into long positions if the fundamentals do not deteriorate. The lack of participation can be gauged by the limited returns of equity hedge funds versus the S&P 500 (Exhibit 5).

Figure 5: Long/short equity hedge fund returns lag those of the S&P 500

long-short-equity-hedge-fund-returns-lag-those-of-the-sp500

Source: Bloomberg and BNPP AM, as of 30/04/2019

Finally, company earnings are still surprising to the upside, but one has to question how much longer this can last if labour costs continue to rise and inflation remains contained. This should eventually compress corporate margins in the absence of strong productivity gains.