Are we in a Goldilocks Phase of the Economic Expansion?
Arash Sotoodehnia, PhD
Financial markets seemed to have shaken off the malaise of late Summer and early Fall. Equities have hit new highs; the yield curve is no-longer inverted (although quite flat to 5-years). The Federal Reserve Open Market Committee has signaled, absent any significant negative shocks to the economy, a likely and lengthy pause in their mid-cycle correction. Chairman Powell indicated that the three cuts of 25 bps to the US federal funds rate has left the economy “in a good place”. The Fed seems to have engineered sufficient accommodation to offset most of the friction caused by the Administration’s trade war with China.
The Bull Market
The current bull market (March 2009 to today), the longest in history, has endured several periods of weakness that ended with a powerful return to risky assets. From 2011-2012 the Eurozone crisis scared investors away from risky assets globally, pushing interest rates to historic lows, with equity prices declining significantly. Investors again moved away from risky assets in 2015-1Q2016 in response to a second bout of concern about the stability of the Euro area especially after the Brexit vote, and finally following the China devaluation event associated with the US-China trade war resulted in markets declining close 20% (almost a bear market) between October and Christmas 2018. Each of these periods was followed by a dramatic increase in equity values:
- From October 2011 to June 2015 the S&P 500 rose 92% after Mario Draghi convinced the market that the European Central Bank would utilize its “monetary bazooka” to save the Euro,
- from February 2016 to February 2018 the S&P 500 rose 57% in the euphoria following the election of the business-friendly Trump administration and its policy initiative to dramatically reduce corporate taxes, and
- from Christmas 2018 to November 11, 2019, the market rose 31% in response to the Fed reversing course and reducing interest rates.
Risk-on vs. Risk-off Episodes
These episodes of the risk-on trade has pushed asset prices dramatically up. The question is that given the extended bull market, is it possible that asset markets can sustain a repeat of the euphoria we witnessed in 2016-2017 (Trump election Euphoria) and again in 2019? It is unlikely.
On the plus side, there is some tentative evidence that the contractionary forces that have hit the world economy have begun to abate. The uncertainty associated with Brexit is beginning to be resolved, and most of the likely negative impacts of Brexit have now been priced-in, although surprises are still possible given that the UK is holding a general election on December 12. Similarly, the Trump administration is beginning to send signals that a phased resolution to the trade fight with China is becoming likely. With the policy uncertainty gradually beginning to be removed, businesses can begin planning for the new normal. To the extent that Brexit and China trade uncertainty suffocated business investment decisions, the new post Brexit and post China policy regimes will allow businesses to begin planning for an environment where the US economy is less intimately tied to China, and where the UK sets sail on it new economic course outside of the EU. In addition, the Federal Reserve has reversed the monetary tightening it had signaled late last year, lowering the cost of capital. Long term interest rates are about 100 bps lower than they were a year ago. The manufacturing sector, which has been at the center of the slowdown shows tentative signs of stabilizing in response to the dramatic reduction in the cost of capital. JP Morgan’s manufacturing index ticked up in October, and at 50.3 (a number above 50 indicates that manufacturing output is expected to rise), is about a point higher than it was three months ago. Manufacturing seems to have bottomed out in Q3 2019. Unfortunately signs of stabilization in the manufacturing sector have been offset by a weakening in services and continuing pressure on agriculture in the US.
Tentative Signs of Stabilization
The tentative signs of stabilization are likely not going to result in a similar increase in asset prices and economic growth as previous recoveries from periods of risk-off behavior by investors. During the 2016-2017 period, growth in global GDP jumped from 2% to 5%, and remained above 4% for several successive quarters. During the 2019 period of risk-on asset growth the Fed reduced short-term interest rates by 75 bps. Important features of these two risk-on recoveries seem unlikely to be repeated this time:
- The US economy is working closer to full employment, with little excess capacity available to be utilized to push growth higher.
- The Trump Administration’s fiscal stimulus was likely a one-time event, with $1 trillion Dollar plus deficits, there is very little room for a similar fiscal move. The IMF estimates that the fiscal stimulus pushed GDP growth up by 1.6% in 2017-18.
- While manufacturing appears to have stabilized, it is not growing, and other sectors are also soft.
- The monetary policy stimulus by the Fed has reduced the room for a similar stimulus in 2020.
- Macro policy in China continues to be focused on deleveraging the shadow banking sector, putting a drag on Chinese growth prospects.
- Eurozone monetary stimulus appears to be running out of steam, with little support in northern European countries for a significant ramping up of additional unconventional monetary stimulus.
- Germany will likely continue to be constrained by its budgetary rules requiring a balanced budget, precluding a significant fiscal stimulus.
Post Q2 Rebound
These arguments suggest that any rebound in global growth in 2020 will be modest and will not replicate the risk-on asset price increases we saw in the 2016-2017 and 2019 periods. Asset prices will be sensitive to news. The market is pricing for a resolution to uncertainty associated with Brexit and the trade war. If either of these surprise negatively, it is likely we will go for a risk-off scenario in 2020 with equity market declines, long term interest rates declining to under 1.5%, and below trend GDP growth rates globally. If these are resolved as the market is now expecting, it is likely that 2020 will see modest economic growth, a modest increase in asset prices including real estate prices, and 10-year treasuries at or above 2%.
I am expecting that absent a negative Brexit, trade war, or geo-political surprise, 2020 will result in a Goldilocks scenario, with negative and positive economic factors balancing each other out to result in modest, non-inflationary economic growth, with modest interest rates, and a modest growth rate in asset prices. Given that the economic tail-winds supporting asset price growth rates in 2020 are likely to be significantly muted relative to the three risk-on scenarios post-financial crisis, identifying winning equity, real estate, or other investments will require much more careful analysis of the fundamentals, more careful vetting of investment opportunities, to find the right value investments. In 2020 positive and economic factors will likely balance themselves resulting in an economy that stays just right, neither too hot, nor too cold. Goldilocks will likely be able to nap piecefully through 2020.
Knowing that there is some risk that we may be surprised negatively by the election in Britain and its impact on Brexit prospects, that the US-China trade dispute may remain unresolved, or that their may be a geopolitical shock, any investment decisions in 2020 should have room to survive through headwinds. In my next BLOG I will look at the commercial real estate sector to identify US markets with positive fundamentals supporting the commercial real estate sector that are likely to generate above average returns in both a Goldilocks scenario or one with a negative shock that pushes us to a risk-off scenario.
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