Market optimism may be misplaced

The market consensus on the global growth outlook for next year is for a \'Goldilocks\' scenario - neither too hot nor too cold. However, the data does not support such an optimistic view.

The market consensus on thet global growth outlook for next year is for a ‘Goldilocks’ scenario – neither too hot nor too cold. However, the data does not support such an optimistic view.

The market consensus on the global growth outlook for next year is for a “Goldilocks” scenario – neither too hot nor too cold. However, the data does not support such an optimistic view.Many observers believe the world economy will see a continuation of the Goldilocks environment, in which growth is neither too hot nor too cold for investors’ comfort. The anticipated moderation in the pace of expansion is expected to support the kind of market environment that was last seen in the mid-1980s and 1990s, whereby a mid-cycle pause in activity allows equities to re-rate.

Despite the longevity of the current cycle, and threats to this outlook on both the upside and downside, low credit spreads, breakeven inflation rates and implied volatility in options markets suggest financial markets are pricing in little chance of anything other than this positive scenario occurring. Perhaps this is because the “known unknowns” in the outlook have been widely discussed for some time.

The consensus is that the decline in the American housing market will only affect the construction sector. While there is expected to be a small drag on activity, it is anticipated that household spending will be supported by continued employment gains and higher real wage increases, a function of an increasingly tight labour market. Data has been broadly supportive of this case – employment has continued to increase at a modest pace and there have been few indications of a marked deceleration in expenditure.

Though some indicators suggest that the worst of the housing downturn is behind us, the risk of a more serious pass through to the broader economy cannot be discounted. On the National Association of Realtors measure of existing American home prices, the average house price has fallen by more than 3% in the past 12 months, the sharpest fall since records began in the early 1970s.

In real terms, the pace of the decline in house prices is only exceeded by the worst periods of recession in 1974 and 1990. Unlike the recent experiences in Britain and Australia, where the housing markets rapidly stabilised after the end of the phase of rising rates, the overhang of unsold housing inventory in America is at historically high levels. This suggests that price softness is likely to persist. Yet even the limited price declines that have occurred have seen mortgage delinquency rates increase, despite low interest rates and rising employment. Deteriorating consumer sentiment and slowing retail spending indicate the consensus may be too optimistic on the growth outlook.

It is equally plausible that an upside inflation surprise could cause a change in sentiment. While headline and core Consumer Price Index readings in America have moderated from their peaks earlier this year, central bankers globally remain hawkish. Federal Reserve governors continue to reiterate that core inflation readings remain “uncomfortably high”. Indeed, the Fed is concerned that the potential growth rate of the economy has slowed markedly – the implication is that the economy is unable to sustain the high growth rates of the past decade without causing inflation to accelerate.

Charlie Bean, chief economist at the Bank of England, presents a similar argument. He says the trends in globalisation and technological advances that contributed to the low-inflation environment of the past decade are unlikely to be repeated and, all else being equal, inflation is likely to run at a faster pace in the coming years than it has in the past.

Again, while the markets faced an inflation scare in the first half of 2006, the data has generally been unsupportive of the case for a persistent inflation problem. Were there to be signs that capacity use or unit labour costs were increasing sharply, then the interest rate cuts priced for 2007 would be unlikely to take place and bond yields could be expected to rise. While interest rate-sensitive equities would struggle, those that benefit from rising business investment, as well as commodity-related sectors, should see outperformance extend.

Equally embedded in the consensus is the assumption that almost regardless of the outcome in America, the rest of the world can grow, as demand will be driven by domestic factors. This view is supported by the rising value of the renminbi, which will boost the Chinese authorities’ wish to see domestic consumption take over from exports and externallyoriented capital expenditure as the main driver of demand.

In addition, the laggards of the 1990s – Germany and Japan – appear to have put this period of underperformance behind them. Yet the recent period of growth has been remarkably synchronised. This leads us to question whether the decoupling will occur as smoothly as markets expect. If economies continue to move in tandem and America does slow, outperformance by US assets is possible, as has happened in the past.

Overall, the consensus sets out a scenario that should be supportive of most asset markets. The fine margin between what markets would consider to be insufficient growth and excessive demand – the low level of risk to the central case priced into financial markets – suggests that, as with interest rate policy at the Fed, portfolio positioning is likely to be highly data dependent, driven by how the future unfolds.