The Fragility of Goldilocks

There is growing belief in "Goldilocks scenario" – a state where low inflation coexists with unbroken economic growth, rallying indices close to historic highs. While anything is plausible in the short term, we think caution is warranted as either inflation will be stickier, or the slowdown will be more pronounced, both posing risks to the equity markets. We highlight a few factors investors should consider

1. Debt Repricing Looms: With interest rates experiencing their most pronounced ascent in a century, starting from near-zero levels, one would have expected a lot of bond losses in the books of financial institutions, and specially FED's balance sheeet. However, while one can avoid reporting losses through the 'held to maturity' classification, the impact of refinancing this debt at significantly higher rates can not be avoided. The daily interest payment burden for the US has swelled from $1 billion to $2 billion per day. Reportedly, Over 30% of the debt is maturing with in a year or so, and the US government is running large deficits which need to be financed. This substantial surge in interest costs could prove to be re-inflationary or prompt cutbacks in other government expenditures, potentially impacting economic growth.
2. Cumulative Nature of Inflation: Inflation's effects accumulate over time, and its adjustment is a protracted process. While markets frequently base their assessments on incremental data and often accurately forecast the inflation trajectory, the increasing number of workers' strikes in the US implies that the real-world adjustment of inflation is far from complete in household balance sheets. The prevailing power imbalance, favoring capital and asset owners who have reaped substantial gains from the Federal Reserve's expansive monetary policies, has hindered wage growth in last two decades if not more. Gaining wage increases in the US can be a protracted, strike-ridden endeavor, as evidenced by rising number of workers striking across industry - and given the tight labour market, they are more likely to succeed now than before
3. Energy Prices and Inflation: Energy prices are a significant factor in inflation, permeating various sectors of the economy. OPEC's steadfast commitment to maintaining elevated prices by curbing supplies suggests that a demand slowdown may not suffice to curb energy-related inflation. Although China's economic slowdown has impacted commodity demand, any resurgence there could exert inflationary pressures.
4. Structurally Inflationary Factors: Structural inflationary forces are at play, driven by the reshoring of manufacturing and geopolitical tensions. As the world strives to reduce its dependence on China, it must realize that alternative sources are likely to be costlier. Geopolitical challenges, encompassing trade disputes and semiconductor battles, are all structurally inflationary. It's challenging to envision that the relocation of manufacturing operations onshore will remain devoid of inflationary repercussions.
5. Declining Pandemic Cash Cushions: The surplus savings delivered to US consumers through the Federal Reserve's pandemic-era monetary policies have acted as a buffer against economic slowdowns and shifts in consumer behavior. However, as these cushions dwindle, the potential for a discernible consumer slowdown becomes more apparent. Some data even hints at mounting defaults in auto loans and credit cards, and as the consumer remains the biggest driver for growth in US economy, one should carefully watch this space for further slowdown

In summary, we remain cautious regarding the market's warm embrace of the Goldilocks scenario. We believe either inflation may prove more stubborn than anticipated, or the impending economic deceleration could be more pronounced within the next 12 months. Investors should exercise prudence, especially as are sitting on AI driven gains for the year. While the Federal Reserve has yet to adopt an aggressive approach, as they align their balance sheet with the United States' economic output levels, the fault lines will become more visible.

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