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Wall Street believes in a ”Goldilocks” scenario

Wall Street believes in a ”Goldilocks” scenario

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Teaser: There is one economic situation that any investor always dreams of, it is named after the American adventurous figure “Goldilocks” – in the financial markets, it means that stocks are rising, bond yields and inflation are low, and all investors go unworried to bed every night – that’s the feeling on Wall Street right now.

The broad US stock index S & P 500 rises steadily again every day and is trading around the record level that was set earlier this year. When considering what stress or turmoil surrounds global trade and international cooperation, then it is quite interesting with Goldilocks’ return to Wall Street- most especially how sustainable it is?

The American GDP growth of 4.1 pct. (annualised) in the second quarter supports the current goldilocks feeling. Behind the growth result is partially election tactics ahead of the midterm elections on the 6th November. The tax reform which Trump implemented half a year ago is designed to give maximum effect around the mid-term elections on the 6th November. For the second quarter, the plan appears to have been successful, as business investments and private consumption were both growth drivers. This should also have a positive effect in the third quarter ahead of the midterm elections, however, the big question is whether the economic impulse becomes self-reinforcing?

The U.S. government has permanently argued that this will be the case, and therefore, it is acceptable with the temporary larger deficit on the state finances. Most economists do not believe that the growth impulses spread, and I share that belief. The tax reform included some benefits for businesses when moving investments forward, and for households, the biggest positive effect is designed to be around the midterm elections. I therefore consider it more likely that the positive effect is temporary, rather than continuing. The high GDP growth in the past quarter was for the same reason foreseen by economists and was priced-in beforehand on Wall Street. The only uncertain factor was the effect of the trade war, which proved to be positive. Importers around the world who import American soybeans and other agricultural products from the USA have been stockpiling before the products were met by new import tariffs in the importers’ own respective countries. Therefore the U.S. agricultural exports and the U.S. GDP rose extraordinarily in the second quarter, which is unlikely to repeat in the future.

I regard the American economy as robust, which of course, is basically supportive for the stock market, but already priced-in as well. The current Goldilocks feeling is in my opinion, significantly helped by surprisingly many good corporate results in the second quarter.

80 pct. of all S & P 500 companies reported better results than expected, which is the highest ratio of positive surprises during the past 10 years.

Looking at another important requirement for a Goldilocks situation, a low and stable inflation, then it seems that bond investors have an almost lazy attitude towards inflation. This is despite the fact that it has now reached 2.9 pct., which is the highest level since 2012.

I am well aware that inflation in the service sector is still under control, and the rise in inflation is partly due to higher energy prices. As usual, I note that we all believe energy prices will fall again or keep steady, thus inflation is expected to drop again. In my view however, there is a growing risk that price increases on food will take over, which will keep the inflation higher for a period that is longer than expected.

I allow myself to call the attitude towards inflation “lazy”.  When looking at graphic one, it shows the yield curve for U.S. government debt up to 30 years maturity. In the 20-year period from 10 to 30 years, there is an interest rate differential, but it is actually just 0.15 percentage points, which is extremely low. The interest rate on a 10-year note is trading at 2.9 pct., which just matches inflation. The yields on longer maturities are only marginally higher and underlines the strong belief that inflation will drop back again.

There is still a lot of liquidity in the financial system that is ongoing and needs to be invested, which contributes to the flat yield curve. But I assess that the biggest reason simply is the belief in a lower inflation – but is it realistic?

As mentioned, I argue that there is an increasing risk that food prices will contribute to the inflation spiral for a period making Goldilocks joy limited. The very low unemployment should increase the risk of the American economy running hot. As graphic two shows, the current unemployment rate is among the lowest since 1948.

Since several years, when I have spoken with Wall Street economists, they have been waiting for the wage inflation to kick-off due to the strong labour market, but reality is different. The latest figures for wage increase in the U.S. show an annual growth of 2.7 pct., though with an inflation at 2.9 pct., the result is a negative real wage growth of 0.2 pct. This is an indication that private consumption cannot support the GDP growth more than already foreseen by the financial markets, but the labour market does so far not generate inflation in any alarming way. The negative real wage growth though is another threat to the Goldilocks feeling, but Trump’s trade war probably contributes to bringing even more imbalances into the economy.

If the trade war expands, it is an increasing danger that private consumption is particularly affected by price increases due to higher tariffs on imported goods, which again poses a risk for the GDP growth. Should growth and private demand remain relatively unaffected by the price increases, then the rising imbalance will be expressed as even higher inflation. This is the risk that I am most certain of, and therefore I continue to argue that the bond market is most at risk compared to the stock market – but whatever happens, my belief is that Goldilocks’ visit on Wall Street is only temporary.

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