Is it Time to Breakup with Goldilocks? – Week Ended 9/14/18

The month of September started a bit challenged following very strong runs in July and August; that is until last week when the S&P500 managed to rebound and conclude the week higher by +1.2% and bring the index back to a little better than break-even for the month-to-date.  With the latest week, the S&P is now up a handsome +10.2% in 2018.  The figure is remarkable considering US equities moved -12% lower between late-January and early-February and spending the better part of 6 months fighting to fully recover against a volatile political and global trade backdrop.  International markets generally cannot claim the same resilience however.  Emerging markets are off -9.2% YTD (and in bear market territory from their highs earlier this year); developed Europe is also negative YTD.  Even within the US, performance is extraordinarily bifurcated; growth (tech, healthcare) enjoys a more than 1000 basis point favoritism vs. value (think energy, utilities, consumer staples).  This growth-over-value bias is a carryover from much of the last several years, but made even more extreme in 2018.  It is tempting to wonder if value (or international for that matter) will ever enjoy a sustained period in the sun again.

In pursuit of not missing the forest for the trees, the economic picture should remain the diversified investor’s primary focus.  In that regard, domestic economic data remains strong.  GDP growth in the US appears to be running at a +7.6% annual pace (including effects of inflation); and a robust purchasing managers index (PMI), a new high in consumer confidence and small business optimism, and an unemployment rate staying below 4%.  In fact, research group Strategas Research Partners noted over the weekend that recent data may be approaching the “too hot” zone.  That might cause you to ask how can an economy be “too hot”?  In short, when one considers that inflation is historically born out of rising wages (which occurs when an economy has tight labor markets) and the Fed’s primary function is to ensure price stability and “full” employment, it makes sense that the monetary authority should continue increasing the cost of money to constrain those measures, especially when the domestic economy suggests it can handle the adjustments.  Several Fed governor speeches lately are in fact sounding more hawkish.  Tariffs also pose their own wrinkles to that stability however in that they are like a tax but also inflationary: they raise prices and at the same time restrict growth.

For much of the last 9 years, the term “Goldilocks” was used to describe the environment as “just right”, neither “not too hot nor too cold”.  Not so hot to generate problematic inflation that would require the Fed to intervene, but not so cool that a recession was a realistic risk.  Now however, with unemployment below 4% and wage growth moving above 3% (historically problematic above 4% because it translated to faster inflation), another Fed hike looks certain this week.  The probability of another in December is also high.  With the yield curve already very flat, those short-end adjustments suggest inversion is likely (meaning short term borrowing costs more than long-term) sometime in 2019.  In the past, a yield curve inversion always caused something in the financial system to break.  It signaled that a policy mistake was made and an economic recession followed within 12 or so months.  Bear in mind, the Fed is well aware of this, and the US economy is like a super tanker – unlikely to go from “great” to “terrible” quickly.  History also shows however that yield curves can be flat without inverting for extended periods; but that would require the Fed to back away from its hawkish rhetoric and/or pause after another hike or two.  Still, the Fed has no reason to abandon its current path so long as the economy appears as “hot” as recent.

From that perspective, it appears it is time for investors to “break-up” with their girlfriend “Goldilocks” when it comes to how they think about the market environment.  Tying that thought back to the extreme dispersion present within the stock market highlighted upfront, it suggests at some point the areas that worked best will become those with the stiffest headwinds; value should provide a better margin of relative safety.  Disciplined investors, aware of the notable divergence in 2018 and recent years, are wise to keep trimming appreciated exposure to the areas of the market most dependent on access to cheap money and the Goldilocks theme.

Posted in Blog Post.