- For the first time in several years, the global economy seems more synchronized.
- The Fed’s liquidity spigot may remain open for much longer than investors anticipated a few months ago.
- The fact that the U.S. economy appears to be firmly rooted in a modest mid-cycle expansion may keep it going for longer than it normally would.
We all know the story of Goldilocks and her porridge. It was not too hot, not too cold, but just right. Over the past year or so, the stock market has been in what I call a Goldilocks sweet spot. The U.S. economy has been expanding at a modest but consistent clip (with real GDP growing at 1.6% year over year as of Q2), inflation has been subdued (with the core Consumer Price Index [CPI] rising 1.7% as of Q2), and the Fed has kept the liquidity spigot wide open through QE3 (at $85 billion per month since September 2012).
Meanwhile, the eurozone economy has stabilized and China appears to be recovering from its slowdown. As of September, 72% of the countries for which Markit/HSBC publishes manufacturing PMI (Purchasing Managers Index) data were in expansion, up from 69% in August and 59% in July. So, for the first time in several years, the global economy seems more synchronized.
In my view, it has been the best of all worlds for stock investors. Economic growth has been positive—but subdued enough to keep both inflation and the Fed at bay, and therefore interest rates low. If growth were much faster or inflation expectations accelerated upward, the Fed could start looking for an exit to its extremely accommodative policy, forcing interest rates higher and creating a negative feedback loop for stocks and bonds alike. But growth has been stubbornly muted, which in a perverse way is just how the markets like it—just right, like Goldilocks’s porridge.
One way to look at this favorable environment is to think about the structural backdrop as consisting of four possible regimes:
- The above-mentioned Goldilocks/reflation regime, which consists of stable growth with low inflation and ample liquidity
- An austerity/deflation regime, which is characterized by economic contraction and deflation; it existed around the world in 2008 and more recently in Europe,
- An inflationary boom regime, in which global growth accelerates and inflation takes off—as it did in early 2011
- An inflationary bust or stagflation regime, in which inflation accelerates after years of easy money, but growth remains sluggish—think 1970s
Needless to say, the most favorable regime for investors is the first one, and that’s the one we have been in for some time now.
What could possibly go wrong? Well, of the three things that the market has going for it—plenty of Fed-induced liquidity, stable but modest growth, and low inflation—a reversal of one or more of these three pillars could upset the apple cart. Specifically, growth could slow or even contract, inflation could accelerate, or the Fed could finally remove the punchbowl.
When will the Fed taper?
How likely are any of these scenarios? Well, starting with a possible reduction in monetary policy, we got a good whiff of that in May and June, when the mere suggestion of a slight tapering of the Fed’s $85 billion-per-month asset purchase program sent the bond market and, to a lesser extent, the stock market into a tailspin. In fact, liquidity conditions tightened so much that it raised doubts about the Fed intention to follow through on its own well-advertised plan. Sure enough, at the September Federal Open Market Committee (FOMC) meeting, the Fed decided not to taper.
This raises the question of when the Fed will be able to reduce or exit QE3, especially now that the fiscal drag over the debt-ceiling impasse is likely to trim growth in the coming months. The government was shut down for two weeks—sending consumer sentiment way down and forcing economists to trim their economic projections.
On top of this, Janet Yellen has been nominated as Fed Chairman Ben Bernanke’s successor. Yellen is considered to be a proponent of nominal GDP targeting, whereby the Fed keeps monetary policy very accommodative until nominal GDP growth reaches a certain upside target. With nominal GDP growth currently at only 3.1% (year over year, as of Q2), that would imply an easy policy for a long time to come. Nominal GDP targeting also implies that the Fed will tolerate a rise in inflation. So perhaps the liquidity spigot will remain wide open for longer than investors anticipated a few months ago, and this could provide a prop for the markets for some time to come.
Will growth slow or contract?
What about growth slowing or contracting? This may be the bigger worry for investors. We already saw in the spring how sensitive the housing sector is to rising interest rates. Just the suggestion of a taper sent bond yields sharply higher, and with them mortgage rates. The fiscal showdown in Washington will likely hurt growth a little, or perhaps even a lot. Also, the current economic cycle is already more than four years old. Given that the typical business cycle lasts around four to five years, we seem to be due for a slowdown or even a recession at some point. The worry is that the Fed is already at full throttle, and that it simply won’t have the tools to fight the next downturn, other than to do more of the same. It’s called pushing on a string.
How likely is a significant slowdown or recession in the months or quarters ahead? Fortunately, at this point it doesn’t seem that likely. The U.S. economy appears to be firmly rooted in a modest but stable mid-cycle expansion, and the very fact that it has been so modest may keep it going for longer than it normally would. Why? Because the inability of the economy to achieve so-called escape velocity—sustained higher growth—will likely keep both inflation and interest rates at bay, and thus the Fed from withdrawing its stimulus. In other words, the slower the expansion, the longer it can last.
It is worth remembering that the Fed has historically planted the seeds for recessions. In the typical cycle, when the economy overheats and inflation accelerates, the Fed applies the breaks and this causes the yield curve to invert as short rates rise faster than long rates. This inversion then leads to a recession or slowdown—the playbook for the typical inflationary boom-bust cycle. But since the late 1990s, and especially since 2007, we have been in a deflationary mindset. So this time around, the historical playbook no longer seems so relevant. Instead, we have the economy now in its fifth year of expansion, inflation is falling, and the Fed is printing money as fast as it did when the expansion was only just starting back in the summer of 2009—a totally different story. In my view, no escape velocity suggests less inflation and no Fed tightening.
Could the economy just roll over here, despite all this easy money? It certainly could. A slowdown or even a contraction driven by fiscal austerity could be a serious headwind for the U.S. economy and could bring it to the same place the eurozone was not too long ago. Indeed, coming back to the four structural regimes, a prolonged fiscal drag could move us from the Goldilocks regime to the austerity/deflation regime, and that would in many ways be the worst of all worlds.
Let’s hope it doesn’t happen. For now, with the Fed unwilling to taper, and with most of the global economy in a modest expansion, it does not appear that bond yields will rise much further (and may even fall) and stocks could continue to follow earnings to new highs.
One caveat here is that earnings growth continues to slow and is now only around 5% (year over year), and valuations have already expanded by almost 50% from their 2009 trough. The S&P 500® Index has gained about 145% on a total return basis since March 2009, while earnings are up 100%. At the March low, the forward operating P/E for the S&P 500 briefly dipped below 10x. At the recent high of 1,730 (on September 19), it was around 14.6x based on an earnings projection of $118/share. So, unless P/E ratios can expand even further, rising valuations could provide a headwind for stocks, unless earnings growth accelerates higher. However, more than four years into the expansion, I’m not sure how plausible that scenario is.
So, what are we left with? Modest but stable growth that is at risk of slowing because of the government shutdown, very low inflation, and a Fed that tried to taper but ultimately didn’t. It all spells Goldilocks, but with a downside risk to growth.