The more things change, the more they stay the same. The world economy has slowed sharply, central banks are worried enough that easing is back on the agenda, yet U.S. stocks this week broke above their September high.
What gives? In a word, Goldilocks. The economy is warm enough that fears of an earnings-crushing recession have gone away, but cool enough that the Federal Reserve won’t raise rates any time soon.
The S&P 500 (.SPX) has returned to its peak under very different conditions to those prevailing when the bull market broke down. As a result, the biggest threat to the stock rebound is the end of the Goldilocks economy, either through a return to fears of recession, or a resurgence of inflation that wakes the Fed’s hawks from their slumber.
The major difference between now and last September is the outlook for inflation. In the autumn investors thought inflation would be at or above the Fed’s target, with a risk that the tight jobs market would lead to a spiral of rising wages and higher prices.
Investors now think inflation will be lower for longer, but not so low that deflation will again be a threat. The probability of inflation above 3% over the next five years has dropped from one-in-five in September to just one-in-10, according to probabilities derived from options markets by the Minneapolis Fed, after matching its post-2008 low at the start of this year. Meanwhile the implied chance of inflation being below 1%, dangerously close to deflation—briefly feared during the December in panic—has receded back to where it stood in September.
As a result Treasury yields have barely bounced, breaking their usual tight link to moves in the stock market. During the late-year swoon, when recession fears dominated and stocks briefly slipped into a bear market (counting intraday trading), bond yields fell alongside share prices, as should be expected.
In this year’s rebound stocks jumped, while bond yields didn’t, because the recovery was a sigh of relief that it was wrong to fear recession, not a new bet on a booming economy.
As relief rallies go, this has been a big one—the best start to the year for the S&P 500 since 1987 (back then, the rally turned into an unsustainable boom, ending horribly in October’s “Black Monday” crash). Recession fears faded in tandem with improved prospects of a trade deal with China and signs that Beijing’s stimulus has helped the Chinese economy avoid a serious slowdown.
The stock market winners since the low on Christmas Eve might suggest the market is anticipating a strong economy: The tech sector is up 37%, closely followed by economically sensitive consumer discretionary and industrial stocks.
But performance since the closing high on Sept. 20 tells a different story. Economically sensitive sectors have generally done rather poorly, with industrials, financials and energy underperforming the S&P 500, while boring utilities and real-estate stocks—often treated as proxies for bonds—beat the go-go tech stocks.
The real market story is of a “meh” economy, not an assumption that a boom is on the way.
But a weak economy is no barrier to strong stock-price performance, as the bull market of the past decade demonstrates.
David Shulman, senior economist at UCLA Anderson Forecast, came up with the notion of the not-too-hot, not-too-cold Goldilocks economy when he was at Salomon Brothers in 1992. “The market’s behaving like we’re in a Goldilocks world, and I think that’s justified the increase in [valuations] for stocks this year,” he says.
The funny thing is that while valuation multiples have risen, there’s been no turnaround in earnings expectations. Earnings expectations for 2019 have tumbled, taking the year-on-year growth forecast by analysts from 10% down to 3%, according to Refinitiv’s IBES data. While earnings estimates for the S&P 500 have stabilized recently, they have not gone back up, unlike stock prices.
This fits the Goldilocks model, where stock prices benefit from rising valuations linked to easy money, even as there is little in the way of profits growth because of the weak economy.
And here lies the danger. Goldilocks can vanish in one gulp if inflation expectations pick up again and investors start to prepare for the return of Fed rate increases. Equally, investors delighted by low and steady inflation will quickly turn and run if it starts to get so low that deflation is once again a risk—especially as the world’s central banks have far less scope to cut rates than they usually do when recession looms.
Still, there’s a good case to be made that after its startling reverse at the beginning of this year, the Fed won’t want to change course again in a hurry. That should help slow any increase in bond yields if inflation does pick up, and give Goldilocks investors time to adjust.
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