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Have we returned to a Goldilocks economy?

Jim Cielinski  |  02 May 2019Text size  Decrease  Increase  |  
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It is unlikely we have returned to a Goldilocks economy. Risk markets are certainly eager to price in a Goldilocks period where there is little inflation, growth is slow and steady, and volatility remains tame, but we are dancing on a knife edge now. The Goldilocks period has worked in the past because central banks – the Bank of Japan, the US Federal Reserve and the European Central Bank – were ready and willing to stimulate economies with trillions of dollars of stimulus. This time, however, we are missing that tool in the tool kit. The ECB really cannot do much, the Bank of Japan has already done most of what it is going to do, and the Fed has only ceased tightening. They are not going to backtrack into big-time easing or monetary stimulus. Without that tool kit, the ability to navigate the narrow course where growth and inflation are just right will be illusory.

Has the US 'had its porridge' with the Trump tax cuts or can growth stabilise again?

Last year, there was almost too much growth and too many inflationary fears in the US We could argue that the porridge, in reference to the Goldilocks analogy, was too hot. Now we are finally seeing growth moderate. It is important, however, that this growth does not slow down too much. So far it has behaved, and the odds are the markets are now pricing in too much short-term deterioration. Make no mistake – this slowdown is global – but the US is coming from a stronger starting point, and I think it will be able to stabilise in the second half at these lower levels.

Could a bear be coming down the path?

It is hard to see a material bear market without some kind of recession and I still believe the odds of a global recession are low. It is interesting that we have flipped back and forth from fearing too high an inflation rate to fearing recession, and while a number of leading indicators of recession suggest that we should be wary, some of the coincident and lagging indicators suggest that we still have some time on our side.

Absent a policy mistake by the Fed, which was one of the biggest fears in terms of potential recession drivers, I think we avoid it for 2019. Do not get complacent, though, as the odds of recession are larger today and there are pressures emanating from several sources. Debt continues to grow; monetary stimulus is no longer acting as a tailwind and margin improvement is dissipating. So, while profits are robust, margin weakness and growing debt expose the markets to potential shock. As we move into 2020, it is important to keep a keen eye on credit growth and margin deterioration and also on what happens in growth engines such as China.

Is China the swing factor for global growth?

When I look at what the important swing factors are for this year, China is right up there. In addition to trade protectionism, they are also combating slowing growth. While they have employed an array of easing measures, the magnitude of what they are doing is relatively small; recent measures only equate to about 20 per cent of what they have done in past easing cycles. Beijing’s hands are tied in an effort to stimulate the economy, and I do not think their efforts will reverse the slowdown we are currently seeing. Although China will likely continue to grow stronger than many regions of the world, the slowdown is going to have an impact on global trade. What happens in China will dictate what risk assets do, as they have spurred roughly two thirds of global credit growth in recent years, which is what greases the gears of global growth.

What are the implications of all this for interest rates?

The obvious answer is lower rates, but most of this move has already happened. The market has priced in the view that nearly all central banks are likely to either stand put or ease. Equally, the downward movement in inflation pressures has been reflected through a much lower term premium. So, I think we have already seen the bulk of the rates decline.

Central banks will not be the big story for the rest of 2019. In my view, it is likely that the Fed and most other banks will not tighten or ease much in the next 12 months. In some cases, the threshold for a policy shift is too high and in other cases, central banks' hands are tied. The story will shift; it will now be more about the pace of the global slowdown in the context of central bank inaction. That means that volatility may persist, but it will be driven by different factors. For me, there would need to be another leg to the global slowdown for rates to go materially lower from here. At this stage, I think one could look at the global slowdown and say it is probable that the Fed’s next move is an ease, and that this tightening cycle could very well be over.

When looking outside the US, there has been a similar decline in rates. Yields in Germany and Japan are less than zero and I think that means two things. One, the potential for big return upside is probably limited and two, it does make the US look relatively attractive.

Rates are low and are going to stay low, but I think the key for fixed income investors is to recognize that even at low yields, there is a diversification benefit. Particularly as you get late in a cycle, owning fixed income and owning high-quality fixed income – whether it is short, medium or long duration – can provide important diversification benefits to a broad portfolio.

 

Takeaways

  • Markets are eager to price in a Goldilocks period, but given major central banks are limited in terms of the stimulus they can inject from here, the ability to navigate the narrow course where growth and inflation are just right will be extremely difficult.
  • Absent a policy mistake by the Fed, the odds of recession in 2019 appear low; however, it will be prudent to keep an eye on whether growing debt, deteriorating margins and the global slowdown tip the balance in 2020.
  • While rates are low, fixed income still offers diversification benefits to a portfolio, particularly as the cycle progresses. In terms of corporate credit, in these late stages, it will be critical to emphasise companies exhibiting prudent balance sheet management.

 

 

is head of global head of fixed income at Janus Henderson

This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. 

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