Morgan Stanley
  • Wealth Management
  • May 7, 2019

Debating the Goldilocks Economy

Many investors are rejoicing that we’re in an economy that’s “not too hot” and “not too cold.” Those conditions may not last.

“Goldilocks,” as an investing term, typically describes an ideal economic backdrop, where growth is decent, but “not too hot” to encourage the U.S. Federal Reserve to hike interest rates, and “not too cold” to result in slower earnings growth. 

Few market narratives have so powerfully and accurately described the first four months of this year. Year-to-date nearly every major asset class is up double digits and the S&P 500 and Nasdaq have both reached all-time highs.

I’m not convinced it will last. Instead of embracing Goldilocks, I think investors should make some defensive moves, such as adding cash or gold, to protect their portfolios against future volatility. 

Below are several factors which may be distorting the economic picture in the first quarter:

  • Shifting Fed policy: In January, the Fed abruptly changed course, ending its plans to continue hiking short-term rates and shrinking its balance sheet, both policies which stood to slow economic growth. Markets took things a step further and priced in future Fed rate cuts, moves it would only need to make if it needed to stimulate the economy. That may not be necessary. The Fed signaled last week that it would be “data dependent” and that a decision to hike or cut rates from here would be dictated by economic results.
  • Trade-related distortions: Ongoing trade disputes, most notably with China, led to a huge buildup in inventories. That seems to have boosted GDP in the first quarter, which was stronger than expected. That trend may well reverse as businesses slow purchases to let inventories decline to more normal levels, causing a drag on growth later in the year.
  • Government shutdown impact: Although the shutdown ended in late January, it may have contributed to weak economic results at the start of the year. Those numbers were shrugged off by investors as the result of a one-time event.
  • Fiscal stimulus from tax cuts: With the Tax Cuts and Jobs Act now over a year old, fiscal stimulus from higher spending and lower taxes is likely to fade through the end of the year.

Despite strength in GDP, new home building and labor markets, I note weakness in other areas that are more forward-looking, such as surveys of manufacturing activity and capital spending plans. Auto sales, too, are sagging. 

Given all the potential distortions in economic data and the aging business cycle, I suggest investors remain cautious and look for ways to insulate their portfolio against future volatility. Adding some cash, short-term bonds and gold could prove a good move if the Goldilocks economy doesn’t stick around that long.   

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