Markets have been unusually well behaved of late. Leaving to one side the odd spasm of volatility, risk assets have done very well over the past year or more. Investors increasingly refer to this risk-on, low-volatility environment as Goldilocks. In this note, we discuss the unusual set of circumstances that supports this Goldilocks equilibrium, why it is inherently unstable and whether we are about to exit this zone of tranquility.
The “just right” macroeconomic outlook
The term Goldilocks is a play on the children’s fable, and in particular the three bowls of porridge that the heroine of the story finds in a deserted cottage, one of which she feels is too hot, another too cold, but the third is “just right”.
It is the macroeconomic outlook in our case that investors find to be “just right” for risk assets. More precisely, investors take comfort from the fact that the growth outlook is thought to be robust, while the outlook for inflation is thought to be anaemic. The former leads to compressed compensation for systemic default risk, because the probability of a recession in the near future is thought to be low. The inflation outlook leads to low bond yields, because the monetary stance is expected to remain loose.
Together the combination of low risk premia and low risk-free rates implies a low discount rate on future earnings which justifies higher valuations. And if future earnings are revised higher on the back of a more optimistic assessment of the growth outlook, then valuations can climb higher still, and have done so.
It is the unconventional nature of the global monetary stance that has proven particularly important in generating this Goldilocks outcome. The combination of negative interest rates and quantitative easing (QE) – central bank purchases of government bonds on an industrial scale – has driven bond yields very low, and in particular long-term bond yields very low, and squeezed risk premia, by driving investors into risk markets in a search for yield.
As a result, unconventional monetary policy has the potential to drive risk asset prices higher, even if negative rates and QE have no impact whatsoever on the real economy and therefore earnings expectations.
Is Goldilocks inherently fragile?
As always, life is more complicated than this. It is not enough that the risk of recession is low to justify a low equity or credit risk premia. Balance sheets must be strong enough and the political backdrop must be stable enough to keep compensation for risk at a minimum.
Likewise, it is not enough that the inflation outlook is anaemic to keep the risk free rate low. Finance ministers must remain focused on fiscal consolidation rather than expansionary measures and central bankers must be relatively relaxed about the financial stability risks from elevated asset prices. Otherwise, central bankers will retreat from their current easy monetary stance, causing the risk-free rate to rise.
These conditions suggest that Goldilocks is inherently fragile because they appear to be mutually inconsistent in the medium term. Strong growth should ultimately lead to stronger inflation. Low interest rates should ultimately lead to more borrowing and weaker balance sheets. Rising asset prices should eventually become a concern for central bankers from a financial stability perspective. And the rapid technological change through automaton that has helped to suppress inflationary pressure by depressing wages can ultimately feed economic and political polarisation that can generate political instability at the ballot box.
Investors have started questioning this year whether Goldilocks can last much longer. We had the correction in volatility markets. Perhaps more importantly, we have had important news on the underlying supports for Goldilocks, at least in the US. The fiscal stance is shifting and investors are gradually becoming more confident about a return of US inflation. Together those two pieces of news threaten to weaken the low risk-free rate support for Goldilocks. Unless earnings expectations rise or the equity risk premium falls in response to those developments, the higher risk-free rate should weight on equity valuations.
If – and it is still if – inflation does return in the US, investors may revise their expectations of what is possible elsewhere too because it would restore confidence in the Phillips Curve relationship between activity and prices that should apply everywhere.
That could trigger a further correction in beliefs, long-term bond yields and ultimately risk asset prices via the discount rate. In particular, a change in view on the inflation outlook in Europe and Japan could trigger a major correction in global bond yields and hence risk asset prices. After all, the negative rate and QE policies of the ECB and the Bank of Japan (BoJ) are doubtless playing a major role in suppressing long-term global risk-free rates.
Global Purchasing Manager Indices (PMIs)
Source: FactSet, BNP Paribas Asset Management, as of 15/03/2018
Is time up for Goldilocks then? Not just yet. The volatility uptick seen at the start of the year has passed and markets have recovered their composure. Inflation has yet to decisively break higher. Growth still looks reasonably good. The global investment community will probably be comfortable searching for yield and taking exposure to risk for a little while longer.
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