Markets are enjoying a Goldilocks environment at the moment: not too hot and not too cold. The conditions are just right for keeping a recession at bay (or at least in the past), and inflation at a comfortable, steady position. The contributors to this “perfect” economic state are clear, with pent up consumer demand, ultra-low monetary policies, plenty of fiscal stimulus and progressing vaccination roll-outs in developed markets increasing.
This Goldilocks state has given the global stock markets a well-deserved boost, most developed markets hitting all-time highs since Q1. The near-perfect economic conditions are reflected in the recovery and positive earnings growth of companies, renewing investors’ confidence and delivering an increase in asset earnings. In addition, commodity prices are surging this year. Futures for lean hogs, corn, crude oil, gasoline and lumber have spiked, as economic demand come roaring back after a year of quarantine.
But just like the storybook, the Goldilocks economy is likely to encounter a big bad wolf: inflation.
In March, the Consumer Price Index (CPI) surged to 2.5%. That’s the highest 12-month increase since August 2018. Simply put, CPI is a monitor of inflation that measures how much prices for key products have increased over a period of time. It takes into account a ‘basket’ of goods and services used by the average household: groceries, gasoline, clothing, medical services and so on.
What does this mean for Goldilocks? Just as inflation erodes buying power, it will also wear away at stock portfolios as it takes its toll on businesses. As prices drop, purchases are delayed as investors wait the market out hoping to snap assets up at even lower prices. Why buy an item today when it’s likely to be on sale tomorrow?
When prices increase, the average household starts tightening its budget belt and cutting back. The knock-on effect is company revenues declining, and profits taking a hit. That, in turn, sees stock valuations fall, and the economy grinds to a slow roll.
Traditionally, the Federal Reserve would combat inflation by increasing interest rates to balance things out until inflation reduced. However, as per a recent announcement, the Fed won’t be running to anyone’s rescue. As a general policy moving forward, the Fed will allow inflation to run its course, reaching uncomfortable levels while interest rates stay low and the economy runs hot.
Head of the Federal Reserve, Jerome Powell, clarified that more emphasis will be placed on boosting employment while allowing inflation to rise above the long-standing target of 2%. Interest rates are likely to be kept low for the next three years. This weeks, US CPI read will test the Feds and investors nerve.
Now we should continue to take advantage of the good times, it important to remain vigilant. Remember, “bull markets don’t die of old age..”. With Goldilocks disappearing into the distance, the fear is that inflation will trigger investors’ defensive position: sell, sell, sell. With stocks edging towards overpriced valuations, inflation and resulting central bank reaction function (first move to reduce balance sheet) could spark a sell-off posing an increased threat to the financial system.