Is "Goldilocks" For Real Or Just Another Fairy Tale?
...everything that typically benefits from "Goldilocks" (stocks, dollar, bonds, economy) will soon head south, while assets that have been under pressure (gold, foreign currencies, various commodities) will make new highs...
Much ado has been made about a possible reappearance of "Goldilocks," but what exactly is Goldilocks?
Goldilocks was the nickname given to the soft-landing in 1995 that kicked off one of the biggest 5-year bull runs in the equity market in history. That soft landing consisted of a slowdown in growth along with a corresponding falling rate of inflation that allowed the Fed to ease, cushion the economy's landing and thereby avoid a recession.
The result back in 1995 was that commodities turned down despite economic growth continuing at a healthy, yet slower pace in the US. Corporate profit growth continued to rise. Long-term interest rates followed the Fed's lead and fell, and earnings multiples on equities expanded as the Fed lowered interest rates and made money "cheaper." The resulting positive financial flows into the equity market and bond market also helped to rally the dollar, as dollars from overseas were "re-invested" back into US financial assets. It truly was a Hollywood-ending. This is the Goldilocks dream, but the odds of a "repeat" of that dream are about as good as the odds of the US military pulling out of Iraq by the November elections.
One of the primary "facts" that many cite as support for a Goldilocks case today is that the rate of inflation is moderating (or in some cases merely "will" moderate); but is that a fact or a fairy tale?
One of the major factors contributing to Goldilocks back in 1995 was obviously the decline in the rate of inflation. And while I believe most government inflation measures are basically "engineered" to show as little inflation as possible, the core CPI (ex-food and energy) is worth looking at for our purposes since even this measure of inflation shows no sign of turning down anytime soon.
Unlike in 1995's soft landing, when the core CPI was already trending down, today the core is making new highs and is above its 200-month moving average for the first time since inflation peaked back in 1980.
But what about the recent drop in oil? What about the fact that the CRB broke its uptrend since the 2001 low? Doesn't all that mean that commodity prices and inflation have peaked? Not really.
Never mind that high commodity prices work their way through the economy and into the prices of goods and services with a lag. The rise in commodity prices doesn't even appear to have abated yet either.
Take a look at a chart of the equal-weighted CRB (CCI) below from October of 1965 through the end of September. The old equal-weighted CRB, which is now the CCI, equally weighted each commodity within the CRB up until June 20, 2005 when the weightings were changed to more than double energy's weighting from 17.6% to 39% of the CRB index.
Not only has the upward trend not been broken during the most recent pullback, but a look at the weekly chart below also reveals that the CCI is once again nearing new highs, this time led by a breakout to new multiyear highs by the grains. Does that look like the inflationary trend has been broken? On the contrary, the rally appears to be about to enter an acceleration stage.
Now, many have cited the fact that the new CRB has broken its trendline going back to 2001 as a sign that the commodity inflation of the past 5 years has ended. With energy being as important and as large a market as it is within the commodity complex, I admit that it makes sense to give it a higher weighting in the CRB index.
The problem with looking at this new CRB is that the apparent "trendline" going back to 2001 is actually completely meaningless, since prior to 6/20/05, the only data that we have is based on the old equal-weighted CRB, which is now the CCI. Thus, the "trendline" break in the CRB that many have cited as signaling that commodity inflation is over, is not in fact a trendline break of anything at all since it combines new oil-heavy CRB data post-6/20/05 with old equal-weighted CRB data pre-6/20/05.
So, if inflation has not peaked, then how can we have Goldilocks? The answer is that we can't. Despite the hopes of many, today's environment is nothing like 1995. We can debate about what that environment is (which I believe is basically stagflationary at best), but it's most definitely not Goldilocks, because the key component of Goldilocks (i.e.- a decline in the rate of inflation) is not present. In fact, not only is rate of inflation not moderating, but we also stand a very good chance of seeing it actually accelerate in the coming months. I am not alone in this view. Consider that former Federal Reserve Chairman Paul Volcker recently said that he's worried both about inflation and pressure on the US central bank to not do anything about it.
If it's not Goldilocks, then how did we get here, and where are we going?
In my view, the Fed has only itself to blame for the current environment. The fact is that the Fed's massive easing following the stock market's peak back in 2000 was in essence a monetization of the biggest stock market bubble in history, and we are now feeling the inflationary consequences of that monetization via rising commodity prices and a chronically weak currency, both of which are highly inflationary.
What about the "deflation" of the housing bubble?
Sure, the housing bubble has popped, but it was the first place to see a dramatic inflation. And it only finally peaked because prices got so whacky relative to income levels that it eventually led to an exhaustion of sorts. Nevertheless, in an environment of a weak dollar and booming emerging markets that are increasingly less dependent on US growth, a drop in US consumption as a result of the housing bubble's implosion is unlikely to be enough to halt the rate of inflation.
What about those who say much of the increases in commodity prices are the result of investment demand and not real world demand?
This is true in my view, but that's what happens when there is too much liquidity in the system with nowhere to go. As I mentioned above, the bottom line is that there is too much money and credit, and it's manifesting itself in the form of rising commodity prices (among other things like record low credit spreads, the private equity boom, etc.).
What many have dubbed the "commodity bubble" is in fact a liquidity bubble or "dollar bubble" that resulted from both the Fed's ultra-easy monetary policy following the collapse of the stock market mania in 2000 and the various imbalances that have been building in the world's financial system for years, many of which were only exacerbated by the Fed's actions in the wake of the mania.
Whether via real world demand or investment demand, the result of commodity inflation is the same. It feeds through into the real world and eventually makes its way into the prices of goods and services, producing "inflation." And the longer the Fed waits to mop it up, the more painful it will be to stop.
Caterpillar's (CAT) lowered guidance last week is a perfect example of the rising costs that companies are seeing as a result of higher commodity prices, which in Caterpillar's case also resulted in the company passing on some of those cost increases to its customers by announcing price hikes for much of its equipment next year.
How does it end?
I don't know how it all ends, but it's definitely not Goldilocks. The most likely and optimistic outcome, given the Fed's propensity to do what is politically "easy," is a long period of stagflation in which the Fed looks the other way (or potentially even tries to ease, depending on how bad the consumer is hurt by the housing bust). This, while inflation accelerates and a slowing consumer-based economy is sandwiched between both a rising cost of living and a housing bust, which takes away not only the housing ATM that the consumer has come to depend on but the jobs that the housing bubble provided as well.
Sure, the Fed may talk "tough" on inflation, just as it has since it "paused" back in August, but its actions (or rather the lack thereof) speak louder than its words. And thus far, the Fed's actions show little or no concern about inflation, which means it's only going to accelerate.
The bond market might not like that idea of course, and it might even show its displeasure by pushing rates in the long end higher, which will have the added effect of accelerating the bust underway in the housing market.
We may even be already witnessing the bond market express its displeasure to some degree. Despite the Goldilocks party hats coming out over the past several weeks, long-term interest rates have been climbing since bottoming in late September. That's not Goldilocks, ladies and gentlemen.
Nevertheless, it's the market's opinion that matters at the end of the day, and for the moment the Goldilocks trade is "working" for the most part. The market is never "wrong," but the market also frequently changes its mind. If the market has it "wrong" about Goldilocks, then the tables will soon be turned.
And if so, everything that typically benefits from Goldilocks (i.e.- stocks, the dollar, bonds, the economy) will soon head south, while those assets that have been under pressure for the past two months (gold, foreign currencies, various commodities, etc.) will roar back to life and make new highs.
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