How to deal with Goldilocks scenario for the global economy

In Goldilocks scenario for  the global economy, central banks that give a sense of where monetary policy is heading, suggest that policy rates will only slowly start to rise.

Last Friday’s US payroll report has been described as a “Goldilocks” number, after the famous fairy tale, in which the porridge was neither too hot, nor  too cold. The payroll report showed that the labour market is hot, with 850k new jobs, but not so hot that the unemployment rate fell; it actually rose a tenth to 5.9%. Looking ahead, we’re likely to see this Goldilocks reference used a lot as investors try to determine whether global economies are on a glide path to sustained growth with modest inflation; or  are at risk of falling off this path and encountering something far more sinister.

The Goldilocks scenario for  the global economy is that supply recovers at the same time as post-pandemic demand levels off. At the same time, the adverse base effects lifting inflation in many countries ease off, allowing annual inflation to fall back towards central bank targets, with onward price pressures reduced by returning supply.

In this scenario, central banks can slowly and steadily reduce support, safe in the knowledge that economies are sufficiently robust to cope with the withdrawal, and the same can be said on the fiscal side as support here ebbs away as well. Unsurprisingly, this is the scenario that policymakers predict, even if they admit that the outlook is very uncertain. In their analysis, the rampant growth we’ve seen so far this year moderates and, as if by magic, inflation moves towards the target.

With this in mind, those central banks that give a sense of where monetary policy is heading, suggest that policy rates will only slowly start to rise. It would seem that this scenario is perfect for  investors; one that’s likely to bring stronger equities, stable or  lower bond yields, and weakness in “safe” currencies like USD, while riskier currencies, such as those in emerging markets rally.

The problem, of course, is that this fairy tale ending may never arise. For  a start, central banks almost  forecast optimistic scenarios where inflation comes back to target. But price risks right now appear more elevated that usual given the uniqueness of the pandemic supply shock. And there are other risks as well. Bubbles are seemingly starting to develop, in housing, for  instance and maybe financial asset prices in general. Debt is very elevated on both the public and private side suggesting significant vulnerability.

Central banks have had to double down on monetary easing and some would say that in doing so they have dug the hole they are in even deeper. All this means that an alternative scenario, where inflation risks are not snuffed out could bring an altogether calamitous situation of rapid central bank tightening, asset price collapses, debt crises and an economic slump. No policymaker is forecasting this and, Mr. Steve Barrow, Head of Standard Bank G10 Strategy suspects, that very few in the private sector  are either. But until it can be sure that inflation is in reasonable check, this nightmare scenario will never be too far away and investors are likely to be constantly looking over their shoulders, with the result that asset prices fail to improve significantly.

“Our own view on this is that inflation risks are, indeed, likely to prove more stubborn than most anticipate. But if stubbornly higher inflation just means that many central banks that were habitually falling short of target are now likely to be on target, or  only slightly higher, then that’s a good thing, not a bad thing. Hence, we reject the debt-crisis/stagflation argument of the doom mongers. But does that mean its unbridled joy for  investors with asset prices rallying hard? No, it does not, partly because the alternative nightmare scenario is sufficiently close to keep investors somewhat cautious and also because the markets already seem to have priced the Goldilocks scenario into current valuations”, Mr. Steve Barrow stressed.