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Goldilocks Growth

Sooner or later, some political shock will disrupt the current happy balance of robust global growth and low inflation, as US President Donald Trump’s trade wars and oil sanctions almost did last year. But until such a shock actually happens, investors can sit back and enjoy their porridge just the way they like it.

LONDON – With Wall Street hitting all-time highs and the US economy certain to set a new record next month, it seems a lifetime since the despondency in financial markets at the end of last year. Fears of recession have been completely refuted, and investors who shared the view expressed here in early January – that markets were just going through a bout of irrational panic – have enjoyed the strongest start to a year since 1998.

The market’s roller-coaster behavior is easy to explain, at least in hindsight. Investors were understandably worried by four risks last year: overly aggressive US monetary tightening; escalation of the US-China trade conflict; soaring oil prices (possibly returning to $100 per barrel or higher); and another euro crisis, precipitated by the unprecedented left-right populist coalition that emerged from Italy’s election. By the end of the year, however, all of these risks had subsided: the Fed executed a dovish U-turn, the US-China trade war moved toward a ceasefire, oil prices fell, and Italy resolved its fiscal clash with the European Commission in a fairly innocuous truce.

With all of these problems receding, the surge in equity prices from January onward was understandable, and even predictable. The question now is whether this rebound will lead to a resumption of the bull market or turn out to be only a temporary bounce.

In my view, the bull market will continue, despite the fact that it has already broken records for longevity. The US economic expansion will also break historic records when it enters its eleventh year in June. The fundamental reason is that the combination of very low inflation and decently strong economic activity that has characterized the world economy since the 2008 financial crisis shows no sign of ending.

This benign outlook may seem at odds with two concepts that have dominated economic commentary since the financial crisis: “secular stagnation” and the “deflationary new normal.” Both have proved misleading and confusing. “Secular stagnation,” at least as a description of global economic activity, is simply wrong. Global growth has averaged 3.7% since the end of the recession in mid-2009, which is actually slightly faster than the 3.6% average in the 30 years to 2008. And there has not been a single year this decade in which global growth fell below 3%.

How could this have happened, given that growth in Europe, the United States, and China has slowed since the crisis? The explanation is simple arithmetic: China and other emerging economies now make up a much larger share of the global economy than in previous decades. Their increasing dominance creates a base effect that outweighs the slowdown in their national growth rates. For example, China’s GDP growth of 6.5% last year, from a base of $14 trillion, contributed twice as much to the increase in global output as in 2007, when its economy grew by 14% from a base of $3.5 trillion.

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This calculation is not just a statistical oddity. Robust and steady GDP growth has been reflected in growing global demand for commodities, energy, and real goods and services, which in turn has translated into robust and steadily growing corporate profits. On the other hand, the concept of a deflationary “new normal” is perfectly valid if we focus on inflation instead of economic growth. In OECD economies, average inflation plunged from an average of 6.2% in the 30 years to 2007 to just 1.9% since 2008.

On Wall Street, the combination of moderate economic growth and very low inflation is commonly called the “Goldilocks economy,” after the fairy tale about a girl who wants her porridge “not too hot and not too cold.” But a crucial feature of the Goldilocks economy is widely misunderstood by investors, economists, and even central bankers: the apparent contradiction between high stock prices, which seem to anticipate strong economic activity, and falling bond yields, which seem to predict global recession or secular stagnation.

Most economists seem to believe that stock markets are over-optimistic and wrong, while bond markets “know something” troublesome about the future and are right. Others argue the opposite. But what both sides miss is that, in a world of persistently moderate growth and persistently low inflation, seemingly optimistic stock markets and seemingly pessimistic bond markets is no contradiction. Sky-high equity prices and rock-bottom bond yields are simply sending messages about totally different subjects.

Equity prices are driven by prospects for real economic activity and the expected corporate profits that will result from it. But bond prices are driven by the prospects for inflation and the expected interest rates that will result from it. In the pre-crisis world, strong economic growth almost invariably meant higher inflation and, therefore, higher interest rates. But during the past decade, the links between economic activity, inflation, and monetary policy that were taken for granted in the 1980s and 1990s have completely broken down. The pre-crisis dogma that inflation “is always and everywhere a monetary phenomenon” has turned out to be nonsense, at least for advanced economies, where central banks have printed money like wallpaper without any inflationary response.

The breakdown of old links between growth and inflation could be due to globalization, technology, demographics, the weakening of organized labor, or other reasons. But whatever the causes, the consequences for financial markets should now be clear. Until the combination of steady growth and low inflation is seriously disrupted, asset prices will remain much higher and bond yields much lower than pre-crisis analysis considered normal. Sooner or later, some political shock will doubtless disrupt the happy balance of robust global growth and low inflation, as US President Donald Trump’s trade wars and oil sanctions almost did last year. But until such a shock actually happens, investors can sit back and enjoy their porridge just the way they like it.;
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