In the fairy tale, Goldilocks hits it third-time-lucky with a bowl of porridge that is neither too hot, nor too cold, but “just right.” Meanwhile, the listener trembles as three bears prowl their way back from the woods.
After enjoying the overheated reflationary expectations of the so-called “Trump trade” earlier this year, markets have also settled back down to a familiar, lukewarm porridge of low growth, low inflation, low interest rates and low return expectations.
There are certainly bears in the woods that could upset the table—but they may stay safely outside, and investors should not lose sight of the bulls that could equally disrupt the Goldilocks scenario.
Three Bears: Poor Data, Policy Stumble, Geopolitical Shock
At preliminary discussions for our forthcoming Asset Allocation Committee Outlook, it was clear that committee members had revised down their 12-month outlooks for most asset classes. Following a brief reflationary rally, we see markets pricing for an environment familiar from the quantitative-easing years, when growth and inflation were low but ample central-bank liquidity limited the risk of recession.
Investors can make money in that environment. It generally favors equity and credit risk over duration. But only just. Return expectations remain muted, risk-taking will likely remain modest, and therefore volatility is suppressed.
The bears stalking this Goldilocks scenario are never far away, simply because the margin for error is tight both for policymakers and investors. It doesn’t take much to hurt confidence, inflict a growth shock and wipe out modest return expectations.
When the business cycle is as extended as this one, when U.S. economic data is softening and when the Federal Reserve wants to “normalize” policy regardless of that data, a poor number, a policy stumble or a geopolitical shock can trigger a more pessimistic turn in the markets. That pessimism is arguably already evident in commodity prices and the U.S. yield curve.
Two Bulls for the Goldilocks Scenario
And yet things are finely balanced. There is a bullish case to be made, too.
The first is for risk assets outside the U.S. The release of new funds for Greece and recent election results have lifted the fog of political risk that has been obscuring Europe’s growth recovery and rising business confidence.
A modest-growth environment also makes faster-growing emerging markets look attractive, particularly as valuations are still recovering. Investors may worry about the impact of a stronger U.S. dollar as the Federal Reserve tightens policy. We would argue that an emphasis on balance-sheet reduction is less dollar-friendly than a quick series of rate hikes, and that currency markets are in any case now more focused on fundamentals than on the Fed. A wrong step by China or a lurch lower for global growth would be bad for emerging markets, but as long as Goldilocks keeps eating porridge we believe they can outperform.
The second bullish case is for active management and, by extension, low-volatility hedge fund strategies. When growth in general is subdued, markets hunt down and reward idiosyncratic growth prospects. This dynamic is already pushing up stock dispersion: Witness recent turmoil in technology stocks and across the retail sector when Amazon made its play for Whole Foods. It may soon push up volatility.
The Reflation-Returns Bull
The third and fiercest bull would charge at any sign of the pro-growth legislation promised in the early days of the Trump administration. The performance of bank stocks suggests lingering anticipation of financial deregulation, but in all other respects the “Trump trade” appears finished. House Speaker Paul Ryan’s speech on tax reform last week gave us little to go on.
Nonetheless, any move could renew confidence that we are still only midway through the current business cycle. When markets position with such consensus, the smallest development can transform investors’ attitudes and cause a lot of volatility. U.S. small caps, which have lagged substantially this year, could do well in either this or the Goldilocks scenario.
And so, like the fairy tale, the markets feel poised for maximum tension as Goldilocks finishes her “just right” porridge and slips into a complacent sleep. Can she hear the bears prowling outside? Does she realize that, in her drowsiness, she might miss the bulls charging by on the other side of the door?
In Case You Missed It
- U.S. Existing Home Sales: +1.1% to SAAR of 5.62 million units in May
- U.S. New Home Sales: +2.9% to SAAR of 610,000 units in May
- Eurozone Purchasing Manager Index: -0.2 to 55.7 in June
What to Watch For
- Monday, 6/26:
- U.S. Durable Goods Orders
- Tuesday, 6/27:
- Case-Shiller Home Prices Index
- U.S. Consumer Confidence
- Thursday, 6/29:
- U.S. 1Q 2017 GDP (Final)
- Friday, 6/30:
- U.S. Personal Income & Outlays
- Eurozone Consumer Price Index
|S&P 500 Index||0.2%||1.2%||10.0%|
|Russell 1000 Index||0.2%||1.3%||9.9%|
|Russell 1000 Growth Index||1.1%||1.2%||15.7%|
|Russell 1000 Value Index||-0.7%||1.3%||4.3%|
|Russell 2000 Index||0.6%||3.3%||4.9%|
|MSCI World Index||0.1%||0.8%||11.5%|
|MSCI EAFE Index||-0.2%||0.1%||14.5%|
|MSCI Emerging Markets Index||1.0%||0.9%||18.4%|
|STOXX Europe 600||-0.2%||-0.8%||16.1%|
|FTSE 100 Index||-0.5%||-1.0%||6.2%|
|CSI 300 Index||3.0%||4.3%||10.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||0.4%|
|Citigroup 10-Year Treasury Index||0.1%||0.6%||3.5%|
|Bloomberg Barclays Municipal Bond Index||0.1%||0.2%||4.1%|
|Bloomberg Barclays US Aggregate Bond Index||0.2%||0.5%||2.9%|
|Bloomberg Barclays Global Aggregate Index||0.0%||0.2%||4.7%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.2%||-0.3%||1.3%|
|BofA Merrill Lynch U.S. High Yield Index||-0.3%||-0.2%||4.6%|
|BofA Merrill Lynch Global High Yield Index||-0.3%||-0.2%||5.7%|
|JP Morgan EMBI Global Diversified Index||-0.3%||0.2%||6.6%|
|JP Morgan GBI-EM Global Diversified Index||-0.4%||0.6%||10.6%|
|U.S. Dollar per British Pounds||-0.5%||-1.3%||3.1%|
|U.S. Dollar per Euro||0.0%||-0.4%||6.2%|
|U.S. Dollar per Japanese Yen||-0.5%||-0.6%||4.8%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.0%||-4.7%||-6.6%|
|FTSE EPRA/NAREIT North America Index||0.0%||3.5%||2.9%|
|FTSE EPRA/NAREIT Global Index||-0.8%||1.8%||8.1%|
|Bloomberg Commodity Index||-2.0%||-3.8%||-8.7%|
|Gold (NYM $/ozt) Continuous Future||0.0%||-1.5%||9.1%|
|Crude Oil (NYM $/bbl) Continuous Future||-3.9%||-11.0%||-19.9%|
Source: FactSet, Neuberger Berman.