Markets Insights

Will 'Goldilocks' theme bear fruit?

Construction workers in Beijing. A China debt crisis could yet prove a risk to the global economy, among other things. The country's struggle with exceptional levels of corporate leverage could also "send jitters through financial markets", said AXA
Construction workers in Beijing. A China debt crisis could yet prove a risk to the global economy, among other things. The country's struggle with exceptional levels of corporate leverage could also "send jitters through financial markets", said AXA Investment Managers.PHOTO: AGENCE FRANCE-PRESSE

Many expect rosy story of equity appreciation to continue in 2018, but beware sting in the fairy tale

The biggest theme, when it comes to forecasts for 2018, is "Goldilocks": A "not too hot, not too cold" environment for the global economy.

With inflation muted and growth chugging merrily along, financial assets are expected to continue appreciating.

As populations age and as technological disruptions keep prices down, central banks have no real reason to withdraw the accommodating monetary policies that have existed since the global financial crisis 10 years ago.

As interest rates stay low, the search for yield continues in all kinds of assets. With bond yields suppressed, keeping one's money in equities seems like the way to go.

This rosy story has been in place for many years now. Stock market indices are at historic highs and investors are wondering how much longer this will last.

What will cause the three bears to return and scare Goldilocks away?

One can take one's pick from the litany of risks, like a China debt crisis, another oil price crash, a geopolitical crisis, a bond liquidity crunch, or a good old recession.

What will cause the three bears to return and scare Goldilocks away?

One can take one's pick from the litany of risks, like a China debt crisis, another oil price crash, a geopolitical crisis, a bond liquidity crunch, or a good old recession.

And if you think economic growth is back with a vengeance, you can choose to doubt whether inflation, a key tenet of the "Goldilocks" story, will stay low forever.

And if you think economic growth is back with a vengeance, you can choose to doubt whether inflation, a key tenet of the "Goldilocks" story, will stay low forever.

"The main risk as I see it is that central banks will remain too generous for too long," said Mr Kevin Gardiner, global investment strategist at Rothschild Wealth Management.

"Using inflation to tackle a perceived debt problem seems to me to be a bit like setting fire to your house to get rid of some damp," he added.

Mr Edward Bonham Carter, vice-chairman at Jupiter Asset Management, wonders how long wage growth can remain subdued, given tight labour markets.

Yet perhaps the link between low unemployment, higher wages and inflation - the vaunted Phillips curve - has been weakened by globalisation and technology, he said.

And then there are valuations. While observers point out that markets do not correct simply because valuations are high, they also acknowledge that the rewards are diminishing relative to the risks.

French bank Societe-Generale points out that US equities are trading above their long-term average and at a level seen only during the dot.com bubble. Higher bond yields will make equities even more expensive relative to bonds.

On the whole, risks have moved away from the political towards the financial, said AXA Investment Managers.

China is still struggling with exceptional levels of corporate leverage, it pointed out. "Even though China has the balance sheet to absorb it, it could send jitters through financial markets, especially at the time when emerging markets could be affected by trade policy issues." On the balance, the outlook remains rosy.

There are still few signs of cyclical excesses that might lead to the next recession, said Rothschild's Mr Gardiner. "Our preferred regions are still emerging Asia, continental Europe and now Japan. Sector-wise we still like technology, financials, healthcare and consumer discretionary - a mix of cyclical and secular growth," he said.

History, however, tells us that a growth-damaging crisis is always around the corner.

A cyclical slowdown, or a geopolitical shock, can drag e-commerce and Internet advertising revenues lower. A damaging financial default can trigger a wave of panic.

Nobody knows. For now, Goldilocks is still past the door, happily sampling her porridge.

Let's hope investors, unlike her, do not fall asleep.

A version of this article appeared in the print edition of The Straits Times on January 01, 2018, with the headline 'Will 'Goldilocks' theme bear fruit?'. Print Edition | Subscribe