A Goldilocks Economy

August 10, 2023

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A Goldilocks environment is described as an ideal state for an economy, in which the economy is growing and inflationary pressures are declining. Equity markets tend to love the Goldilocks scenario. However, that does not mean it will always be a smooth ride.

In July global financial markets continued to move higher, with most major markets generating positive returns for the second consecutive month. Asian markets led this dynamic with Chinese stocks posting the largest returns. The strong rally in Chinese stocks boosted the performance of emerging markets equities while industrial metals benefited from this improvement in sentiment towards Chinese risk assets.

Softer Inflation

As expected, the Fed raised interest rates by another 25 basis points in July. Chairman Powell stated that potential future hikes will be data dependent. However, as the interest rate rises, the impact of Fed hikes becomes less and less. Another 25 basis points at current levels is not going to be a driving factor for most business decisions. Therefore, we do not expect a large impact from monetary policy in the coming year. At this point, monetary and fiscal policies are pretty much priced in, and it will take a new policy mistake or shock to hit the U.S. economy hard enough to start a recession in the near term.

In July inflation data again came in weaker than expected with the Consumer Price Index, Producer Price Index, import prices and export prices all lower than the market expected. For the past 8 months, we have been expecting that inflation would weaken faster than expected, while economic growth would be stronger. Now it is time to start to think about what will happen next.

Much of the base effect that helped to lower inflation is now behind us. For instance, in July of last year we had negative inflation, which means we will likely see a slightly higher annual inflation rate for July than for June.

Looking forward, if we assume a monthly inflation number of 0.3% for the next six months, then we get 3.5% for the annual change in headline U.S. inflation in December. If we use 0.2%, which was the average of the past three months, we will get to 2.9%. The Fed is in the middle, expecting 3.2%, or 0.25% monthly. Although this number is still higher than what the Fed says it is comfortable with, a 3% inflation number is not a major risk to the economy like the 8% we saw last year was.

Unlike headline numbers, core U.S. inflation is poised to decline further over the coming months. Nevertheless, there is uncertainty over how quickly core inflation will fall against the backdrop of a resilient economy.

It looks like the U.S. economy is about to get more boring. The economy continues to grow, while inflation is likely to become more stable. The focus will now shift to the strength of the job market.

At the moment, the job market seems to be quite stable too. New job creation was a little lower than expected last month but the unemployment rate held steady at around 3.5%.

Decent Q2 Corporate Earnings

The second quarter earnings season was again quite strong across the board relative to expectations. Earnings growth will likely turn positive in 2H23, thanks to improving sales growth. Decreasing input costs will be a positive for all sectors, as that will help offset the margin pressures from fading pricing power. Though higher labor costs are still a downside risk, they could be offset by continued productivity growth.

The technology, communications and consumer discretionary sectors should be able to deliver strong numbers into year-end because of the weak earnings in these sectors late last year. Technology sector earnings contracted by 10% in Q4-2022, so growing by 12.6% in Q4-2023 will be nothing but a reversal. The Communications Services and Consumer Discretionary sector earnings are expected to rebound by 47% and 21% respectively in Q4-2023 after the Q4-2022 contraction of 28% and 16%.

We should not forget that despite this year’s market recovery, most markets are still trading well below the levels of January 2022, while we did not experience a recession and while corporate profit margins are holding up well. That makes us believe there could be more upside in equity markets. Especially in Europe and Asia, which have been lagging the recovery in the U.S. market.

Higher Wages and Higher Productivity

The key to sustained improvements in living standards in any economy is higher productivity, which means being able to produce more desirable goods and services with fewer hours worked. In the second quarter, real GDP rose 2.4%, but hours worked were up only 0.2%, as the impact of sustained hiring was offset by a shorter workweek. The implied 2.2% annualized growth rate in productivity means that a 5.3% rise in wages generated only a 3.1% growth rate in unit labor costs. Again, that is only a slight squeeze on profit margins given that the nominal economy grew at 2.2% annualized rate. That is why companies have been able to maintain profit margins and why earnings keep outperforming market expectations.

AI Will Destroy Jobs and Increase Productivity

The one thing we are sure of is that Artificial Intelligence (AI) will destroy jobs, and hopefully millions of them. Every successful new technology has reduced the need for humans to work as hard. The amount of work a person will provide over a lifetime to finance maximum satisfaction has been falling since the end of the dark ages; less hours per day, less days per week, more holidays per year, fewer years before retirement, and more education before starting work.

There will initially be a lot of focus on those who are directly impacted by AI but societies won’t reject the benefits of productivity enhancing developments. Those that try to protect the old ways often suffer, as others make the shift more quickly. We expect that AI will push productivity higher in the coming years. Productivity and corporate profits are highly correlated, and current strong margins argue for faster technological investment and adoption, which should sustain margins and extend the economic cycle.

Recent U.S. data is supporting this view with Real GDP increasing by 2.4% in Q2, well above most estimates of potential growth. The New York Fed’s Weekly Economic Index has looked up recently, suggesting that growth momentum remained strong going into the third quarter.

The Atlanta Fed’s GDPNow model’s initial estimate of Q3 growth is a solid 3.5%. Both the Citi and the Bloomberg economic surprise indices are well in positive territory.

Bottom line, we are seeing several reasons to be optimistic. 1.5%-2% annualized growth, with inflation falling to 2% on sustained Fed commitment, and already profitable companies sharing improving productivity growth with workers through higher wages, should keep the global economy humming along.

China is Not Spending Enough

The conventional wisdom is that China’s economy has too much debt and is too reliant on residential property construction and its exports as drivers of growth. While there is truth to these claims, they ignore a key problem that China has, which is high private sector savings.

The macro-economic definition of savings is the difference between what a country produces and what it consumes. In China, savings account for 45% of GDP, by far the highest of any large economy. High savings can often be more of a virtue than a vice, as they provide the resources to expand an economy’s productive capacity. However, when an economy cannot turn its savings into productive investment, they can become a source of weak demand and chronic unemployment, which will encourage households to save even more.

Another problem in China is the troubled property market. For the past twenty years Chinese property prices have been rising, which meant it was an attractive asset class for people to invest in. The problem now is that the prices are very elevated compared to rental yields and there has been too much construction, aka supply, heading into a period of declining population, aka demand.

This is reminiscent of the Japanese property market in the late 1980s. In Japan the collapse of the property market led to a multi-decade stagnant economy. Does China face the same fate as Japan did three decades ago? The answer is perhaps, but we think it is unlikely.

First, the Chinese government will actively try to stabilise the property market. Secondly, in the early 1990s, output-per-hour worked in Japan was nearly 70% of U.S. levels. Today, output-per-hour in China is only 20% of U.S. levels. Thus, China could still grow reasonably quickly simply by increasing productivity towards developed economy levels.

What Japan needed at the time, and to some extent still needs today, was a highly accommodative fiscal policy. If the private sector wishes to be a net saver, then the government needs to be a net spender to ensure that aggregate demand does not fall short of the economy’s productive capacity. China would also benefit from increased fiscal spending.

The good news is that China does not face a trade-off between increasing fiscal spending and a higher government debt-to-GDP ratio. Fiscal stimulus could lower debt-to-GDP by lifting nominal incomes. The bad news is that the authorities have so far been slow to stimulate the economy.

But as long as inflation remains a concern in the rest of the world, the fact that China is exporting deflation is actually helping to sustain a goldilocks scenario for the U.S. economy.

We are now seeing nascent signs that the bad news has gotten bad enough and that the Chinese government understands these trade-offs. The rhetoric has shifted from stability and control to growth and support at the highest levels of government and we expect that in coming months the various agencies will begin to issue pro-growth policies and support for the Chinese economy.

Portfolio Positioning

In July we saw a broadening of the equity market rally, which is benefitting our diversified core portfolios, as different parts of the portfolio performed well. Commodities, Financials and U.S. small and midcap stocks – all of which underperformed in the first half of the year – delivered solid above market returns in July.

The U.S. Treasury yields rose in recent weeks, though have already retraced more than half that rise. Currently we are still underweight portfolio duration, but we believe there is going to be a moment in the next few months where it will be attractive to increase duration in the fixed income part of the portfolio.

We also expect to see further strength in commodity prices in the coming months as continued OPEC supply discipline and Black Sea conflict, combined with increase demand from a growing global economy, put pressure on energy prices.

DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.

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