The last time we referenced ‘Goldilocks’ in our writings was back in September 2018 (“Goldilocks Enters the Breach”), a paradoxically similar yet different environment from the one we face today as the U.S. economy emerges from the global pandemic.
Back then, the U.S. economy was experiencing robust employment and business conditions supporting historic levels of corporate profitability but without the wage growth that would spark an acceleration in inflation. Yes, the Trump Administration was engaged in a ‘trade conflict’ with China, which had weighed on ex-U.S. investor sentiment and put pressure on foreign currency values as the Fed was threatening to embark on a cycle of rate hikes. Yet, U.S. equities continued their advance despite the threat of higher interest rates as investors enjoyed strong profit growth as long-term inflation expectations hovered around 2%, just as they do today.
As was the case in the mid-to-late 1990s when strategists were falling all over themselves proclaiming that the U.S. economy had embarked on a new era of corporate profitability driven by technological innovation that would keep inflation pressures at bay, we witness a similar sentiment today, as encapsulated by Mr. Dimon’s annual shareholder letter. We may see inflation come back with higher interest rates, but only if such a scenario reflects economic normalization as we move past the pandemic and is not due to the types of concerns that plagued the markets during the stagflationary period of the 1970s.
To Mr. Dimon’s credit, his shareholder letter also addresses tangible and existential risks to the ‘Goldilocks’ scenario, whether inflationary pressures, competition from shadow banking players not subject to bank regulations and oversight, and overseas perceptions (primarily from China) that the U.S. is falling behind on education, innovation, and infrastructure. Regardless of whether you believe Mr. Dimon ‘jinxed’ the Goldilocks Moment by his mere mention of it, his letter is definitely worth a full read.
As to ‘Goldilocks’, according to the 4/9/2021 edition of Factset Earnings Insight, Wall Street consensus expects S&P 500 earnings growth of 26.3% for CY2021 driven by 9.7% revenue growth yet Federal Reserve Officials and mainstream economists still maintain that any upcoming inflationary pressures will prove to be ‘transitory’ as a result of ‘base effects’ due to the year-over-year comparisons from the worst of the pandemic shutdowns of last year. Hot enough for profit growth but cool enough not to see a sustained inflationary breakout.
However, with respect to differences between today versus 2018 or even 1998, one of the main differences is the state of real (inflation-adjusted) interest rates. As we pointed out in our 1st Quarter 2021 Market Commentary, real rates remain in negative territory (Figure 1) despite the massive amount of fiscal stimulus in response to the pandemic shutdowns as well double-digit growth in the monetary base (M2 money supply). In the 1st quarter commentary, we mentioned Federal Reserve ‘taper’ risk could serve as the catalyst for a sharp rise in real rates, but so far that risk has yet to materialize with the Fed committed to keeping rates near the zero bound until 2023 or thereafter.
Figure 1 – Goldilocks with COVID: Real (Inflation-Adjusted) Rates Remain Negative
Source: Bloomberg
If we were experiencing Goldilocks in the mid-1990s or 2018 with positive real interest rates, then today’s Goldilocks with negative real rates is akin to ‘Goldilocks’ happily eating her porridge while still suffering from the effects of COVID. A Goldilocks still struggling with the effects from COVID is consistent with the goals expressed by Fed Reserve officials that labor markets need to see a “broad and inclusive” recovery before the Fed would consider raising rates. This week’s Northern Trust economic commentary speaks to this condition where pandemic-induced unemployment has not reached pre-pandemic levels whether measuring the labor force participation rate or employment-to-population ratio. So, we should not be surprised to see real interest rates track employment conditions as long as the Fed sticks to its current accommodative stance.
Today’s investor risk appetite may feel euphoric, but there are still lingering pandemic effects that both the Biden Administration and the Federal Reserve believe warrant maintaining the current emergency support measures. But there can be little dispute that elevated equity and credit market valuations near their 10-year highs are discounting a Goldilocks Moment, and any surprise on the inflationary front or disappointment on the growth front could trip up capital markets priced with little room for error.
Add implied volatility (both equity and fixed income) to the list of financial assets settling into a state of complacency. Figure 2 compares the most recent implied volatility futures curve of the S&P (VIX) versus the one priced in at the end of January 2020, right before the pandemic shutdown. Today’s volatility risk curve, with the front-end lower priced near levels before the pandemic, is consistent with investor complacency priced into global risk assets and elevated valuations. The steepness of today’s curve is inviting speculators to start shorting volatility which had been the popular trade throughout 2017 before an inflationary surprise in early 2018 that catalyzed blowing up the short vol trade. Granted, longer dated futures are priced for higher expected risk (possibly due to lingering effects from the pandemic), but barring another ‘black swan’ tail risk event, these longer dated futures could eventually roll down to today’s lower risk levels.
Figure 2 – Today’s Implied Risk (Black Line) Priced into Equity Options Is Near Levels Prior to the Pandemic Shutdown from Last Year (Blue Line)
In addition, Option Gamma, or the volatility-of-volatility (see VVIX in Figure 3), has reached record high levels as option dealers scramble to hedge their option activity due to elevated demand for call options (the so-called gamma squeeze as first observed last August), emblematic of the investor euphoria in risk asset pricing. According to the 4/18/2021 Bear Traps Report, a breakdown in the correlation between ‘delta’ (implied volatility) and ‘gamma’ (volatility-of-volatility) has historically preceded periods of market weakness as the suppression of implied volatility is driven more by technical factors (dealer gamma hedging) than fundamentals.
Figure 3 – The Volatility-of-Volatility (Gamma) Continues to Rise as Option Dealers Struggle to Hedge Their Exposure to Rising Demand for Equity Call Options
Source: Bear Traps Report, 4/18/2021
So, we may very well be entering a ‘Goldilocks Moment’ where a global economy is precariously tip toeing on a tightwire between deflation and inflation with the former driven by the lingering effects from the pandemic and the latter driven by unprecedented levels of government stimulus spending and borrowing. Equity and fixed income risk-based assets have priced in a Goldilocks scenario, so do not be surprised if volatility returns to a (leveraged) market not priced for imperfection.
