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September 27, 2017

The end of the Goldilocks era in economics

By Spear's

Will the end of the not too hot, not too cold economy bring back the bears, asks Guy Monson

The Goldilocks economy – ‘not too hot, not too cold’ – has been the backbone of the five-year bull market, but might it now be fading? Economic growth feels too hot for increasingly nervous central bankers, but a bit too cold to sustain today’s ambitious profit forecasts.

After nearly a decade of austerity and restructuring, a synchronised global expansion is at last a reality. But while better growth prospects will have economists breathing a
little easier, equity and bond investors need to be more circumspect. Synchronised global growth also implies a simultaneous desire to tighten policy after nearly a decade
of universal super-loose conditions.

Until very recently, central bankers seemed relaxed, even as unemployment levels collapsed in the US, Japan and now the UK to levels that economists would historically have been expected to trigger inflation. In recent months, though, some have started to argue against this complacency, suggesting that today’s breakdown in the Phillips curve might only be temporary.

The US has begun the process of interest rate normalisation, with four 0.25 per cent rises (to 1.25 per cent). The Bank of England may be next. Although withdrawal of ultra-loose policies is being carefully calibrated by central banks, world debt levels are high and interest rate sensitivity is therefore uncertain. Also, while modest rate moves seem unlikely to radically alter consumer or business behaviour individually, collectively they could induce an ‘air pocket’ in global growth.

Moreover, it is policy around vast central bank balance sheets that holds the greatest risk for financial markets. These bloated holdings of bonds have cushioned the global economy from events such as the sudden collapse in commodity prices in late 2015 and the UK referendum and US election results in 2016. They have blessed financial markets with extraordinarily low levels of volatility. Arguably, they have also bred complacency among bond and equity investors.

Again, the US is at the forefront of ‘normalisation’. The Federal Reserve has indicated that it would like to start the process of (slowly) shrinking its balance sheet. These moves will likely compound the tightening in global liquidity that has already been introduced by policy makers in China, who have become concerned about the sharp acceleration in house prices.

UK consumer price inflation has accelerated sharply from 0.5 per cent in June 2016 to 2.6 per cent in June 2017 (retail price inflation stands at 3.5 per cent), prompting calls by several Bank of England Monetary Policy Committee (MPC) members to raise the bank rate. Yet ten-year gilts yield a mere 1.18 per cent, and comparable maturity single-A corporates just 2.1 per cent.

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Either yields are too low, or market participants have unshakeable confidence that the inflation rise will be temporary. Inflation should ease back after peaking at the end of this year, provided there are no ‘second round’ effects. It will stick if there are compensatory rises in wages and firms attempt to sustain profit margins.

While global economic growth has been gaining momentum, parts of the industrial world still appear to be under the grip of secular deflation. Although the wider commodity sell-off is much smaller than during previous oil price declines, nickel, silver, natural gas, sugar and orange juice are all down this year.

Meanwhile, the ‘Amazon effect’ continues to damage the conventional retail sector and associated property assets (especially US malls).

In short, significant areas of the global equity markets are off limits  to growth investors, and their capital continues to be channelled into the more highly priced secular growth stories. The result is that though equity prices have continued to rise, they have grown significantly faster than underlying earnings.

The ‘not too hot, not too cold’ economy was never going to last for ever. We are entering uncharted territory – one where the global liquidity tide is starting to go out but where corporate profit expectations are already very full. Moreover, with central banks highlighting the over-valuation of financial markets, a small setback in financial markets is unlikely to halt their carefully drawn plans for policy normalisation. In fact, it may even be seen as desirable.

Guy Monson is the chief investment officer and managing partner of Sarasin & Partners. Subitha Subramaniam, chief economist and head of asset management, also contributed to this article

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