Is this the Goldilocks Economy?
Friday’s non-farm payroll report continues to show evidence of a growing economy and a better backdrop for the U.S. workforce. Payrolls increased by 209,000 in July, and June and May’s net employment figures were revised marginally higher by 2,000. Additionally, wage growth improved in the period, showing a 2.5% annual growth rate in average hourly earnings. The unemployment rate in the United States now registers at 4.3% (a very low level by historical standards) and over 146.6 million people are recorded as employed in the payroll data, more than any other time in American history. In addition to the strong labor market data, corporations in the U.S. continue to post better than expected earnings. Factset (a financial data provider) data show that of the 84% of the S&P 500 companies that have reported earnings figures for Q2 2017, 72% have reported better earnings than consensus estimates and 70% of companies have reported better than expected revenue.[1]
The economic and financial market recovery and expansion, now entering its 8th year, has been roundly described as “the most hated bull market in history”. Following the financial crisis, market observers, prognosticators, and investors have been on the prowl for the next asset bubble, and maybe that’s been a healthy check on the economy and financial markets. With an accommodative monetary policy from the Fed and other central banks, alongside renewed investor discipline and cautious behavior by most lenders and borrowers, economic and financial conditions may have set up just the right mix to support the mythical “Goldilocks economy”. While investors should delight in the results of such conditions, it is important to remain focused on long-term objectives and risk tolerance in the face of a market tempting investors to act recklessly.
As equity indices reach record highs, financial markets have confirmed that the economy has now fully recovered and expanded beyond one of the worst recessions in modern times. Corporate profits are near all-time highs, and growing faster than analyst expectations. It should come as no surprise that markets have confirmed the strength of the economy (low but sustained growth globally), supported by better than expected corporate earnings figures. Furthermore, equity and credit markets lack broad based signs of froth. Exceptions exist where valuations of particular growth stocks look a bit rosy, but are certainly not beyond recent trend growth nor beyond achievable valuations based on future cash flows. The enthusiasm for new business models and technologies in the IT and consumer sectors has not irrationally migrated to all areas of public equity and debt markets. Equity market earnings multiples are marginally above average at 17.7 times forward 12 month earnings, and credit spreads are tighter than normal, but modest premiums to history are seemingly grounded by a fairly rational financial marketplace. Interest rates are low globally and growth is slightly better than expected. These conditions provide a backdrop for better than average pricing for risk. In comparison to recent bubbles (dot-com, housing), valuation anomalies (like FANG stocks) look well contained and within the framework of a model of “rational expectations”. Markets appear to be on the rich side of fair value, but not irrationally exuberant.
While there aren’t any glaring signals portending the imminent end of this growth, the best course of action for portfolio managers and investors is to remain focused on objectives and risk tolerance in a time when market calm may provide a false sense of security. This may very well be a “Goldilocks Economy”. Such an economy neither runs too hot nor too cold, but just right: producing sustained growth with low levels of inflation, keeping the Fed from raising rates too quickly and finding a neutral monetary policy. While this scenario is certainly achievable for some time, recent economic history would suggest such a condition of sustained growth is as mythical as the fairy-tale. Economic cycles still exist. Despite prospective advances in risk management, monetary policy analysis, and computing power, the future is still unpredictable and the collective decisions of fallible human beings still remain the driving force behind the economy. As my colleague, Chuck Lieberman has written recently, let’s enjoy the present economic conditions and remain optimistic about the future because positive data continues to support such a view. Recognize, however, that taking undue risk in the face of a complacent market may be tempting, but it does not make a great long-term investing strategy.
In “Goldilocks and Three Bears”, the protagonist gets too comfortable when trespassing into the home of the three bears as she samples their porridge and falls asleep in the bears’ beds, only to awake and flee when the three bears come home to find her where she shouldn’t be. While, the economy remains strong and market valuations can be justified, investors should not be oblivious to the inherent risks associated with investing. In this period of calmness in financial markets, it is a great time to review investment objectives and check if portfolios are in line with risk tolerances. There is no clear reason why economic and corporate profit growth should end any time soon, but it is best to remain disciplined and avoid assuming inappropriate investment risks. Bears, in fairy-tales and in markets, have a vicious way of correcting bad behavior.
[1] https://insight.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_080417.pdf
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