Goldilocks Versus Bull Trap

Further evidence of disinflation has become visible across western economies. While non-core inflation continues to be unusually high, the trend is clearly on a downward path, as are other macro-economic signals.  It follows almost two years of aggressive monetary tightening across a large swathe of central banks around the world, with one or two exceptions.

In the US, the most important of markets, the jury is out on whether the economy will enter a recession or not, with signs indicating the possibility of both a potential recession or none. There is thus the legitimate conclusion to be reached that a “soft landing” has been achieved.

This lies at the core of the mixed messages between Mr. Market and leading central banks. Whilst the latter’s job is no longer always to look ahead (instead paying more attention to incoming data), financial markets, and especially stock markets, inherently fulfil that very role. Today, many pundits, especially economists, would do well to remember that iron rule. Instead, however, these observers have strenuously argued that “markets are wrong”. That is a risky call at any time.

But it is an important question. Were most observers to be right, the technical bull market experienced in share prices since autumn of 2022 would turn out to have been a false dawn. If world economies deteriorate and corporate earnings reflect this downturn in the coming months, share prices could react and slide. At the same time, if central banks persist with their hawkish acts or even just hawkish tones, fixed income markets could also react negatively.

To complicate the equation, the Chinese economy is experiencing sluggish growth, contrary to expectations that followed the country’s long-awaited emergence from Covid lockdowns. Given the absence of the sort of monetary stimulus measures used in western economies, the risk is one of a deflationary bust, according to experts, which would be accentuated by a conceivable sharp decline in the Renminbi’s external value and deflation exported internationally. And this lack of monetary stimulus would help explain the weak share price returns and lack of confidence experienced throughout the current year. Most recently, however, the Chinese government has announced measures to boost consumption, which were noted by financial markets.

As expected, the leading western central banks continued on their tightening path in the last few days, with the usual accompanying comments that give succour to both sides of the debate about who is right, the market or the economists. Here again, however, financial markets have taken the rise in interest rates in their stride, indicating once again their inclination to look across the valley.

In spite of the inflationary landscape not yet having reached the point of neutrality, stock markets around the world have been grinding higher, with some parts displaying signs of speculation. In part this is due to a liquidity background that is not only positive but, furthermore, consistent with a view that quantitative easing in the US is alive and kicking. To summarise the important message given here ((67) Fed’s Shadow Liquidity Is Pumping Up New Bull Market (Here’s How) | Michael Howell – YouTube), and as pointed out to me by my colleague Chara, liquidity is what flows through markets, rather than through the economy via conventional money supply. This is cash and credit available for investment in financial assets; this is driven not just by central banks but by banks and shadow-banks. It can be measured through the ratio of credit to collateral; this is different from liquidity in the real economy, where any weakness is often mirrored by corresponding strength in financial markets (reminiscent of the whack-a-mole phenomenon in which reduced corporate working capital requirements find their way into financial markets as long as the economy remains weak or stagnant, and vice versa). A closer look at this situation will reveal that the Federal Reserve is neutralising its quantitative tightening through an accompanying programme of quantitative easing.

Although a somewhat complicated picture, the conclusion is that liquidity is alive and well in financial markets and can be expected to remain so for the next two or three years.

As world economic growth remains surprisingly resilient and liquidity alive and well, the remaining question centres on valuation. As we have pointed out many times before in our newsletters, the common approach to valuing investments through the ratio of their price to their earnings can often be misleading and does not sit well with the Quality Growth investor. And the longer the time horizon of the Quality Growth investor, the less relevant this topic becomes.

If the goldilocks reality has it over the bull trap, Quality Growth investors’ risk remains as contained as their expected returns on investment remain high over the long term.

P. Seilern

July 27^th, 2023

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