Equity markets have had a strong year - the MSCI AC World developed market index turned in its 13th consecutive month of gains in November. Other gauges of equity markets have had similarly strong runs and risky assets generally have outperformed in 2017 (see Exhibit 1 below).
At the moment, one word keeps cropping up in discussions about the current state of the economy and markets: Goldilocks - the idea that the system is in a sweet spot where conditions are 'just right' for risk assets.
Goldilocks is a label that is regularly used to describe a state of equilibrium where an economy is running at a pace 'hot' enough to drive earnings growth without inflationary pressure, but not so 'cool' as to suggest that credit or recession risk is imminent.
Exhibit 1: Goldilocks - a sweet spot for risky assets - graph shows performance of selected asset indices for the period from 01/01/17 to 30/11/17Source: Bloomberg, BNP Paribas Asset Management, as of 30/11/2017
So what happens next? Where are those bears ?
2017 is drawing to a close, so what matters now is whether this Goldilocks state of non-inflationary, constant expansion (NICE) is sustainable. And the principal known unknown in answering that question is the outlook for inflation. If the system is to remain in the grip of Goldilocks, it will require a prolongation of the anaemic rates of inflation that have been a feature of the post-crisis recovery.
How likely is that? Here are some thoughts:
- The global economy is currently firing on all cylinders. In 2017, the US, Europe, and China experienced the longest period of synchronised robust growth since 2008. Unless this time is different, a simultaneous expansion should eventually face the challenge of rising inflation and rising interest rates. However, the relatively high level of unemployment in Europe, excess capacity in China and persistent deflationary gusts from ageing populations and technological change could well mean that the danger of the porridge overheating is still years away.
- If conventional measures of inflation continue to remain below central banks' targets then all the signs are that central banks will err on the side of over-stimulating economies through accommodative polices rather than embarking on aggressive tightening. An abrupt return to pre-crisis monetary conditions seems highly unlikely. On this basis the potential returns offered by equity markets remain very attractive in a low yield, low-inflation environment.
- The 'bowl of porridge is half full' view suggests that so far quantitative easing (QE) is working. In 2014, the US Federal Reserve which led the way with non-conventional policy measures, began reducing asset purchases before stopping them completely. Since then it has raised interest rates on four occasions in 25 basis point increments (and a fifth hike is expected this month). Normalisation is underway but it is a very gradual process with central banks tentative and cautious in the absence of inflation.
- Somewhat fortuitously (for porridge lovers) the gradual reversal of the Fed's policies is counterbalanced by ongoing asset purchases by the European Central Bank and the Bank of Japan albeit at a slower pace (see Exhibit 2 below). So, expansion in G3 central bank balance sheets should continue to remove interest-rate risk in 2018 and effectively 'sedate' sovereign bond markets.
Exhibit 2: The withdrawal of the Federal Reserve's monetary stimulus is counterbalanced by continued expansion of balance sheets at the ECB and BOJSource: Bloomberg, BNP Paribas Asset Management, as of 30/11/2017
Central bank balance sheets and cumulative growth rate projections
Just as central bank policies are desynchronised so are the economic cycles in the US, Europe and Japan. While the US cycle may be close to maturity the investment cycles in Europe, Japan and the emerging markets are just starting to find some real traction with strong rises in profits and low interest rates. There is scope for economic growth to continue and become self-sustaining.
A fairy tale for equity markets?
Loose monetary policy is an integral element of the current Goldilocks scenario. Central banks have played a major role in recent years in determining financial market returns in recent years. But over the long-term, trends in asset prices are determined by real (non-monetary) factors.
Today's low interest rates may reflect a structural imbalance in the world between excessive savings and limited scope for profitable investment. If low interest rates reflect the prospect of chronically weak rates of future economic growth there will be less porridge to go around. In this context the challenges posed by ageing populations and heavy debt burdens are greater and the range of possible political outcomes wider.
There are (always) plenty of bears in the woods
Goldilocks is a fragile paradigm, which requires us to believe that a virtuous cycle is underway with central bank support gradually giving way to self-sustaining growth.
If however economic growth were to slow in developed economies then policymakers, having used much of their powder, will be challenged to arrest that decline (this may explain their caution). Another recession would raise political risk and the prospect of nationalism and protectionism.
Take Goldilocks seriously...
As always, the list of what could go wrong is endless. The strength of the search for yield means asset valuations can rise exponentially when optimism gets the upper hand so market overshoots seem inevitable. But in our view, valuations on equity markets are not excessive and the lack of euphoria suggests many investors are not taking Goldilocks seriously.
Written on 30/11/2017