abrdn: Goldilocks – fact or fiction?

Porridge getting cold?

Over the past 18 months, the term ‘Goldilocks’ has increasingly been used to describe the global economic climate – neither too ‘hot’ to cause rampant inflation, nor too ‘cold’ to fall into recession. In such an environment, interest rates can remain low. This happy set of circumstances has been positive for virtually all asset classes, especially riskier assets such as equities, where key indices breached successive record highs in 2017.

The crucial question is, can this positive state persist? And, if so, for how long?

In answer to the question: “Will it continue?”, the Greeks would answer unequivocally not. “Panta rhei” or “all things are in flux” reminds us that the porridge will eventually cool. Indeed, history is peppered with memorable pronouncements of prosperity and stability, and of things being “different this time”, only for such utterances to be rudely disproven not long afterwards.

Here to stay…

And yet, the belief that the Goldilocks scenario will continue has become the mainstream view among investors. There are certainly powerful arguments supporting their opinion.

• Global growth started strengthening in 2016, when a sizeable stimulus from China served to kick-start the global economy. Since then, fading political risks in Europe, continued central bank support and US dollar weakness have fuelled synchronised growth across both developed and developing economies.
• Looking ahead, there are plenty of drivers to sustain this momentum. A substantial stimulus programme should boost US growth by around 0.6 percentage points in both 2018 and 2019. There are also encouraging signs that business investment and labour productivity are picking up in the US, the Eurozone and Japan. As businesses expand to meet growing demand, this could sustain Goldilocks - and the benign market backdrop that accompanies her - for some time to come.
• Despite strengthening economic activity and falling unemployment, core inflation outside the US remains subdued. This could be because there is more slack in the global economy than figures suggest, or inflation is being dampened by long-term structural changes such as globalisation and automation. Inflation in developed markets will probably increase as slack in the economy lessens over the next year or two but, outside the US, is likely to remain below central bank targets. In emerging market economies, there still appears to be a substantial amount of slack, which should keep inflation at bay. It was arguably a more pessimistic view of the prospects for inflation that led to the market “correction” in February. Further evidence of a continued benign outlook for inflation could therefore be a considerable support for markets.
• Given the lack of inflation, central banks can take a fairly sanguine approach, raising rates only very gradually. Even in the US, where further rate hikes are expected this year and next, the pace is very measured by historical standards.

… or edging towards the exit?

While there are sound reasons to believe the Goldilocks scenario can continue for some time to come, the case for suggesting it is already weakening is equally strong.

• The essential ingredient underpinning Goldilocks has been the large amount of surplus capacity in the global economy. This slack has allowed activity to strengthen without the build-up of inflationary pressure that has, in the past, accompanied strong economic growth. As this slack has been taken up, at least in developed economies, wage and price inflation has begun nudging upwards. This could prompt central banks to raise rates faster than investors currently expect.
• There has also been some evidence in recent months that global demand is cooling. Purchasing managers’ indices (PMIs) – an important measure of global economic health – and our own macro-momentum indicator have dipped since early-2018. Certainly, it would be surprising if Europe or Japan could sustain the historically high levels of growth they have shown of late. Also, China is clearly slowing following its big 2016 stimulus.
• In addition, central bank action – and markets’ possible reaction to it – may be less benign than the Goldilocks scenario foresees. Crucially, by early-2019, the major central banks will effectively be engaged in ‘quantitative tightening’, reversing the programme of monetary support that has helped underpin markets since the 2008 financial crisis.

The ‘long goodbye’

The evidence suggests that the three pillars of Goldilocks – strong growth, subdued inflation and very cautious central banks – are still in place. However, they have started to look more shaky than six months ago. On balance, we believe the most likely outcome is ‘a long goodbye to Goldilocks’, summarised as follows.

• The tail-wind of the US stimulus package, and the benefits for emerging markets of weak US dollar, should lift global growth to a post-crisis high of 3.9% this year.
• Growth is then likely to moderate in 2019 and 2020, as economies run up against capacity constraints, the effects of US stimulus fade and China slows.
• As slack in the advanced economies is used up, inflation looks set to rise, although only modestly, given structural factors such as globalisation and automation.
• The US Federal Reserve may hike rates as often as once per quarter over the next year or so. Other central banks can, however, afford to be more cautious, given the relatively subdued inflation outlook.

There are both upside and downside risks to this view, although the downside risks dominate. The end of the Goldilocks era could be hastened by trade wars; an inflation shock that prompts more aggressive interest rate rises from central banks; geopolitical threats; or slower-than-expected growth in China.

Conversely, Goldilocks could be more long-lived than we anticipate. There may be more slack in the global economy than we have estimated, keeping inflation and interest rates lower for longer; the upswing in trade and investment could become a self-sustaining, longer-term trend; or productivity could finally rebound.

When will markets discount Goldilocks’ demise? The crucial issue of timing

Current asset valuations suggest that investors are factoring in a continuation of Goldilocks for some time to come. When might they start pricing, instead, for a worsening outlook?

Regardless of how long Goldilocks continues, markets will almost certainly reflect the onset of more gloomy conditions well before their effects are felt by the world economy. History reminds us that the swing from positive to negative investor sentiment can be swift and painful. Indeed, the recent volatility in markets may be a sign that some investors are getting nervous about the possibility that the Goldilocks combination could already be weakening.

A brief survey carried out at our Investment Forum at end-March revealed that 71% of respondents believe Goldilocks will continue a while longer. Whether or not this turns out to be true, however, virtually all respondents expect the market to begin discounting a gloomier outlook either this year (50%) or in 2019 (46%).

As ever, the investment balancing act is a difficult one. On the positive side, money remains cheap, corporate profits remain plentiful and evidence for the much-feared inflation problem remains thin on the ground. However, we are late in this economic cycle; central banks are in the process of slowing or reversing their quantitative easing experiments; and we have seen some ingredients in the inflation mix that could worry markets and policy makers.

On balance, the Forum wishes to remain “risk-facing”, while paying careful attention to the quality of assets held in our portfolios. It is also important that there is sufficient diversification to ensure that our portfolios can survive the bumps in the road – whether these bumps are expected or unexpected.

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