The Goldilocks Zone

Favorable recent US economic data points to an economy returning to the “Goldilocks” zone of “not too hot, not too cold” economic growth.¹ Slow (but positive) growth could allow the inflation rate to stabilize in the 1-3% range that has been the historic sweet spot for US equity returns.² This optimism has ignited the most recent market rally and sent stock valuations to relatively expensive levels on most key metrics.³ In addition, equity market sentiment has turned positive, with the AAII Sentiment Survey on 7/19/23 showing over 50% bullish for the first time since April 2021.⁴

What happened to all the worries about high inflation and a looming recession? While the inflation and economic picture for the United States certainly looks brighter than expected at this point, there continues to be concern on both fronts:

US Economic Scenario A: Goldilocks

• In this scenario, once thought improbable but now becoming the consensus forecast, the year-over-year inflation rate continues to fall for benign reasons such as lapping the high prices of last year, improving supply chain logistics, and higher labor force participation.
• Economic growth slows but never turns negative, and the jobs market stays healthy but not tight enough to cause high wage growth.
• The Federal Reserve is now done hiking and is able to slowly reduce interest rates starting in 2024 as they no longer need to be so high to combat inflation, supporting further economic growth.

US Economic Scenario B: Economic growth/inflation remain too high, prompting further interest rate hikes

• While the year-over-year inflation rate has dropped considerably, core CPI growth for July was still +4.7% in this morning’s release, well above the Fed’s 2% target.
• Some inflation sources remain too high in the most recent data, including July wage growth at +0.4% month-over-month, implying a greater than 4% ongoing rate.
  • Wage inflation could be exacerbated going forward by recent labor union developments including a new Teamsters contract at UPS, ongoing strikes in Hollywood, and looming strikes by the United Auto Workers.⁵
• Commodity prices (oil, natural gas, copper, etc.) have been on the rise lately, signaling higher expected economic growth and reversing what had been a key source of disinflation.
• Based on many metrics, a US economic recession already happened in 2022 or early 2023, at least in manufacturing, and now we may be in recovery mode with higher growth to follow.⁶  
• Future inflation expectations recently rose above 2.5% to levels last seen in April 2022.⁷ 
• The US government continues to provide a large dose of fiscal stimulus, with the 2023 budget deficit projected to be $1.4 trillion.⁸

US Economic Scenario C: Recession  

• Recession was the consensus forecast in the second half of 2022.⁹ The thought was that the Federal Reserve would have to put the United States into recession to bring soaring inflation down to target, like they did in 1980. The Fed has raised the Fed Funds Rate target from 0% in March 2022 to 5.5% today. In addition, it has been engaged in Quantitative Tightening, or reducing the amount of financial assets owned by the Fed. The assumption was that these actions would have a fairly swift effect in sending the US economy into recession, and in some industries like manufacturing, this is what has happened. However, for much of the economy such as services and employment, the higher interest rates have had little effect so far but may impact future demand growth:
  • While new mortgage rates have skyrocketed, the average homeowner still has a very low fixed rate thanks to refinancing in 2020 and 2021.¹⁰
  • Similarly, corporations did record amounts of long-term bond issuance in 2020 and 2021 and are still paying these ultra-low coupons on their debt despite high rates for new debt.¹¹
  • The debt ceiling showdown delayed the effects of quantitative tightening, but it is now back in full force.
• Excess savings from pandemic-era stimulus programs is expected to run out by early 2024.¹² Likewise, student loan payments are set to resume on September 1 following more than three years of forbearance.¹³
• Bank lending standards have tightened considerably since the March banking crisis, depriving the economy of credit needed for growth.¹⁴
• Corporate defaults are rising thanks to high interest rates and tighter lending standards for companies who were not able to extend maturities in 2020 and 2021.¹⁵
• The yield curve remains highly inverted and this has historically been a signal of an upcoming future recession given the expectation of future rate cuts.

Bottom line

We are not trying to pour cold water on the recent optimism, but rather remind clients that future economic data could still chart many different courses. Macroeconomic forecasting is notoriously difficult and we do not know if it will be Scenario A, B, C, or a truly unpredicted D that plays out going forward. Economic conditions outside the United States will also play a major role, such as China’s uneven post-COVID-lockdown recovery, Europe’s pressured consumer, and new developments in the Russia/Ukraine War.^{16, 17}  Therefore, in our opinion, it continues to be critical to maintain a well-diversified portfolio and stick to your target risk level in these good times as well as the bad. We acknowledge the improving US economic prospects but remain grounded, knowing that historically, the best prospective equity returns have been following periods when investors are scared and a multitude of worries leads to low starting valuations, not when investors are bullish and current valuations assume good times ahead.

At GGS, we continue to stay disciplined and maintain strict risk controls on client portfolios’ beta levels and diversification. In our individual equity selection process, we are primarily focused on long-term competitive advantages, but we also strive to understand how changes in near-term economic conditions could impact the company, as well as clients’ overall portfolios. For now, let’s go enjoy a bowl of “just right” porridge!