Is the stock market right about Goldilocks?

Legendary American broadcaster Edward R. Murrow is known for many pungent epithets, but one of this column’s favourites is, “Anyone who isn’t confused really doesn’t understand the situation.” And right now, investors are entitled to feel confused because stock, bond, currency and commodity markets are giving out different signals. They cannot all be right.

“Equities seem to be pricing in a return to the ‘Goldilocks’ economy of the 2010s, where low inflation, low growth and low interest rates prevailed.”

• Equities seem to be pricing in a return to the ‘Goldilocks’ economy of the 2010s, where low inflation, low growth and low interest rates prevailed. Nothing ran too hot, and everything felt just right, at least if a portfolio was heavily exposed to long-term growth plays such as technology companies, which were highly prized for their ability to increase earnings whatever the economic conditions. America’s stock market is heavily weighted towards tech, and it is outperforming again in 2023, as seen by how the increase in the market capitalisation of the so-called Magnificent Seven of Alphabet, Amazon, Apple, Meta Microsoft, NVIDIA, and Tesla is responsible for the vast bulk of the advance in total US market cap this year.

Seven big tech stocks have fired US equities higher in 2023

Source: Refinitiv data

• Currencies seem to be buying into this view, at least to the degree that the US economy is seen as outperforming that of everyone else. The dollar is on the rise once more, at least if the DXY (or ‘Dixie’) trade-weighted basket is a dependable guide.

“Fixed-income markets remain convinced a recession is coming.”

• Fixed-income markets remain convinced a recession is coming. The yield curve remains steeply inverted in both the US and UK, as ten-year Government bonds offer a lesser yield than their two-year equivalents. This is usually seen as a warning that a slowdown is coming, because bond investors are pricing in future interest rate cuts in response to the downturn.

Yield curves are warning of a recession

Source: Refinitiv data

• Commodities are somewhere in between. Orange juice and cocoa are surging, as are oil and uranium, while precious metals hold firm, but industrial metals are weak (aluminium) or going nowhere fast (copper, tin). Higher energy prices may point to stagflation, if not inflation.

A ‘Goldilocks’ scenario, an inflationary boom, a deflationary slump or a stagflationary quagmire all remain possible outcomes and not even central bankers know what is coming next, given how the US Federal Reserve, European Central Bank and the Bank of England are approaching every interest rate decision, while the Bank of Japan continues to do nothing at all.

“The really hard part is that each scenario potentially requires a different portfolio solution and asset allocation strategy, at least if history is any guide.”

The really hard part is that each scenario potentially requires a different portfolio solution and asset allocation strategy, at least if history is any guide.

Range of outcomes

The ‘Goldilocks’ scenario just feels too easy and too simplistic, especially after fifteen years of unorthodox, ultra-loose monetary policy and then the post-2020 explosion of fiscal stimulus. Equities may like it, but this column is not convinced, although this does make life much simpler for portfolio builders, because it is It is easy to make a case for any one of the other three scenarios:

• Inflation could result from onshoring or friendshoring and the reversal of globalisation (as this will mean more expensive, Western labour); trade unions flexing their muscles and demanding higher wages at a time of low unemployment; and America in particular continuing to pump federal subsidies and grants into its economy courtesy of the Biden administration’s CHIPS and Inflation Reduction Acts.
• Deflation, or disinflation, could yet result as technology continues to drive productivity and automation reduces the need for staff and workers; rising interest bills weigh heavily upon Governments, consumers and corporations alike; and the supply-side bottlenecks and dislocations of 2021-22 start to ease.
• Stagflation, perhaps the worst of all worlds, could yet result owing to global debt levels, which stand at record highs and where interest payments suck cash away from other, more productive investments and hold back growth. Sustained increases in energy prices would also be a worry here, as they filter through to so many parts of the economy and could also fuel higher wage demands to create the vicious upward price cycle seen in the 1970s.

Raw deal

If forced to guess, this column would sit in the inflation (or stagflation) camp and if a forty-year period of cheap money, cheap labour, cheap energy and cheap goods is coming to an end, then it may not be sensible to expect what worked in that period (long-duration assets like tech and Government bonds) to keep working. If the mood music changes, then value, small-caps and raw materials (and other things that central banks cannot print) may be the way forward.

Is equities’ ten-year outperformance of commodities ending?

Source: Refinitiv data

“Equities massively outperformed in the 1990s, commodities led in the 2000s and then equities stormed back in the 2010s. The chart suggests the tide may be about to turn again.”

This column’s crystal ball is no better than anyone else’s but, in search of guidance, it will continue to look at one chart in particular. This is the relative performance of the S&P 500 against the Bloomberg Commodities Index. Equities massively outperformed in the 1990s, commodities led in the 2000s and then equities stormed back in the 2010s. The chart suggests the tide may be about to turn again. We shall see.

Past performance is not a guide to future performance and some investments need to be held for the long term.