What happened to Goldilocks?

31 January 2019

3 minute read

A ‘Goldilocks’ economy is often described as one that’s not too hot, and not too cold – the best state for an economy to be in. The overall investment environment has recently been reminiscent of this, but is that starting to change?

Who's this for? Confident investors

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • Are we moving away from a ‘Goldilocks’ economy?
  • What do recent Brexit developments mean for UK equities?
  • What messages have central banks delivered?

Investors grappled with an economic slowdown and heightened anxiety of possibly tipping into a recession late last year. While we are now starting to see central banks incorporating the recent developments in their projections, 2019 has started on a friendlier tone for financial markets.

Stock prices across the board have gained mid-to-high single digit returns during January. Given this turnaround, our indicators currently suggest that investors have become excessively bullish in the near term.

To be optimistic on the stock market has generally been the right call for investors over the past few years. Throughout this elongated economic expansion, despite various isolated pressure points, the overall environment for investors has been reminiscent of ‘Goldilocks’1: not too warm and not too cold. Inflation has largely been dormant, with the economy expanding close to trend growth while corporate profits growth have delivered consistent equity returns to investors.

However, we think that the outlook for developed market equities appears more fragile than over recent years. Corporate earnings underpin equity returns, and while we believe that a global economic recession is not imminent, the recent deterioration in macroeconomic data has made us more concerned as to what extent developed market corporates can generate sufficient earnings growth to meet market expectations.

Adequate diversification across different asset classes and geographies remains the most cost-efficient protection for the average investor.

Brexit distractions

This week also provided us with plenty of ongoing noise from the UK political backdrop. It is still hard to say whether Tuesday night’s votes on some of the suggested amendments to the UK’s withdrawal plans actually shed more light on the Brexit process or less. There are more pivotal meetings, negotiations and votes to come in the weeks ahead, with a second attempt to approve a withdrawal agreement likely in mid-February.

Sterling’s response to all of this has, so far, been reasonably muted. The appreciation in the UK’s currency seen so far this year suggests that investors have been tentatively pricing in ever reduced chances of the UK exiting the EU without a deal at the end of March. That risk remains, but we currently agree with markets that it is likely a diminishing risk, with some form of negotiated exit still by far the more likely scenario.

Investors able to look beyond the political tumult, and a clearly listing UK economy, will see appeal in UK equities. Besides, the world economy will barely notice the manner in which the UK exits the EU, and it is to the world that most capital markets, even those domiciled in the UK, look to for primary influence.

Central banks in focus

As the UK continues to fixate on the battle for parliamentary control of the Brexit process, it has actually been the world’s central banks that have delivered the most important messages for investors.

Prospective interest rate rises have been delayed amidst a softer economic backdrop. Both the European Central Bank (ECB) and Bank of Japan (BoJ) indicated that downside risks have increased, as external factors have weighed on economic growth. In particular, for Europe, the incoming data continues to be weaker than expected. Late last year the Federal Reserve (Fed) adjusted its language to reflect that it will adopt a more patient approach. Financial markets have interpreted this as a stop to Fed policy rate increases, and even the possibility of them easing in the next two years.

It appears that major central banks are becoming more cautious, while financial markets are now pricing in major central banks not raising monetary policy rates anytime soon.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances. Smart Investor doesn’t offer personal financial advice. If you’re not sure about investing, seek independent advice.

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