A growing belief in a Goldilocks economic outcome for the U.S. has sent stock markets to all-time highs. Market bulls have been aided by the Federal Reserve, which is acting like its fight against inflation is in the rearview mirror and has loosened financial conditions. We believe that while a soft landing is very possible, a recession could still come to pass, or inflation may re-accelerate. Meanwhile, valuations are at historically rich levels. We think the current setup in equities demands caution.
Executive Summary
Stock markets continue to scale new heights as we enter the second quarter. Investors appear convinced that a soft landing is in store for the U.S. economy – a “Goldilocks” outcome in which inflation has been tamed but a recession is avoided. Add a U.S. Federal Reserve (the “Fed”) that seems intent on cutting interest rates, along with the ongoing generative AI mania, and you get what currently feels like euphoria for equities.
There is indeed considerable evidence at present for a soft-landing scenario. Previous monetary tightening has led to a modest softening of aggregate demand. This progress is reflected in a cooling labour market, as well as declining consumer price inflation. Meanwhile, consensus estimates for 2024 U.S. GDP growth have settled in around the 2% mark, a perfect “not too hot, not too cold” level1.
Investors sense that the Fed is keen to loosen monetary policy and will likely start slashing rates in time to avert an economic downturn. Members of the Federal Open Market Committee (“FOMC”) (most notably Chair Jerome Powell) have jawboned financial conditions into easing, and the FOMC’s March “dot plot” suggested that less restrictive policy is on the way. We believe easier financial conditions and expectations of a dovish Fed have contributed to the bull run for stocks.
Plentiful liquidity has also been a tailwind. The process of quantitative tightening (QT), in which the Fed shrinks its balance sheet, should have caused liquidity to contract over time. However, several factors that are somewhat out of the Fed’s control have helped drive liquidity higher rather than lower, injecting more cash into the U.S. economy. These include changes to both the U.S. Treasury’s General Account (TGA) balance and the reverse repo facility (RRP). Increased liquidity from these two programs has resulted in what has been dubbed a “stealth quantitative easing.”
There are, however, significant risks to the current Goldilocks narrative. First, while stock markets have marched higher, government bond markets have not kept pace. Long-term U.S. Treasury yields are now higher than they were at the end of 2023, the yield curve remains inverted, and markets have already scaled back expectations for rate cuts. The bond market’s warning signs contrast sharply with the complacency seen among equity investors.
This complacency comes at a time when stock valuations are frothy. Some of this elevated valuation can be attributed to the narrow group of “Magnificent Seven” tech stocks, which have become very crowded trades. That said, the current exuberance in stocks is not limited to large-cap tech.
Indeed, data show that the rest of market is also expensive versus history. According to Ned Davis Research, the median P/E multiple of the top ten stocks in the S&P 500 is 2.6 standard deviations above the long-term mean, while the bottom 490 is not that much lower, at 1.8 standard deviations above2.
Despite the evidence for a Goldilocks outcome, we don’t believe it’s a done deal. As we argued last quarter, we think the Fed may have a problem getting through the so-called “last mile” on inflation, which could have negative implications for the soft-landing narrative. The pandemic had an outsized impact on inflation due to supply chain disruptions, and that impact is largely in the rearview mirror. But we believe there are underlying inflationary pressures that remain, in the form of longer-term supply-demand imbalances (principally in labour, housing and commodities).
Our belief is that not enough time has passed with restrictive monetary policy to allow the supply-demand imbalances in these areas to alleviate themselves. Therefore, a near-term easing cycle could lead to these inflationary pressures returning sooner than desired by central bankers, leading in turn to a new tightening cycle much more quickly than in cycles over the past couple of decades.
There are risks to equities, even if the Fed is successful in sticking a soft landing. Tactically, we would prefer to “buy the dips,” so long as the U.S. maintains positive growth with generally subdued inflation. Longer-term, though, we worry that the soft-landing narrative could be upset, either by an economic contraction or reaccelerating inflation. It’s worth remembering, after all, that at the end of the Goldilocks fairy tale, the bears do return.
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1Source: Bloomberg, L.P., Picton Mahoney Asset Management Research, as at February 2024.
