The difficult economic balance of “not too hot, not too cold” needs inflation to fall to target while the economy keeps growing, allowing for rate cuts. Here’s why we think it could happen
Optimism over inflation and interest rates have faded through 2024
While the sentiment shift on interest rate cuts this year appears dramatic, we should bear in mind that the “Goldilocks scenario” represents a difficult economic balance of “not too hot and not too cold”. Inflation needs to fall back to target while the economy keeps growing, allowing for interest rate cuts. Risks can equally come from too much economic growth as well as too little.
The US economy has been leading the way since the Covid-19 lockdown ended, while growth in the UK and Europe was anaemic. But if growth in the US now slows, this should create room for the Federal Reserve (Fed) to cut rates, even as economic recovery in the UK and Europe supports global growth.
At the heart of the current Goldilocks scenario is a virtuous cycle of falling inflation driving both real income gains and moderating wage growth, allowing for interest rate cuts even as the economy grows. We see more flexible labour markets, including in Europe, enabling this process and bypassing the need for a recession.
The US presidential election represents a significant uncertainty with the outcome a coin-toss, as is the contest for both Senate and House. I have previously urged people to read Donald Trump’s 2025 Project website as it is radical and involves significant policy shifts were he to become the next president. If Republicans win control of both House and Senate, barriers to change will be limited. The UK election outcome is less uncertain, as is the outlook, with the desire to be seen as responsible stewards of the economy constraining both Labour and Tories’ desire to be radical.
The Goldilocks combination of continued growth with falling inflation and interest rates is positive for capital markets. Therefore, while we think that government bonds offer the best historical value, we also like equities.
Figure 1: Interest rate cuts expected by end-2024
Source: Columbia Threadneedle Investments and Bloomberg as at 23 May 2024
The first half of Goldilocks – continued economic growth – is in place
The biggest recent improvement is in the UK, which has gone from being the most disappointing economy to, if not the best, then certainly the most surprisingly good. I have been highlighting the UK recovery since the start of the year, and it is now increasingly reflected in market forecasts (Figure 2).
Figure 2: Forecasts for UK growth rise
Consensus forecasts for GDP growth 2024 Q4 on year earlier
Source: Columbia Threadneedle Investments and Bloomberg as at 21 May 2024. X-axis shows date forecast was made. Estimates and forecasts are provided for illustrative purposes only. They are not a guarantee of future performance and should not be relied upon for any investment decision. Estimates are based on assumptions and subject to change without notice.
The scenario of improving real incomes driving improving confidence to produce much firmer consumer spending is visible in both the UK and Europe. Fears over energy costs had led consumers to continue to increase their savings, which means that the subsequent unlocking will offer a sustained boost to growth.
The US consumer has already spent its “Covid piggy bank” to avert recession in 2021/22. Now, as the US consumer slightly retrenches, we expect soggy consumer spending. That doesn’t mean recession, but there will not be the vigorous vibrancy we have seen of late in the US economy. However, this could be a better balance for the Goldilocks scenario.
PMIs have improved in Japan and China, indicating that both economies should continue to grow. While important structural issues remain, we see positive developments in Japan and believe that the pessimism over China is exaggerated.
Is US inflation too sticky to allow for rate cuts?
Headline US inflation has been below 4% for a year now, as energy prices fell back earlier. However, it has not fallen below 3%, as it has in both the eurozone and the UK, where inflation peaked later but subsequently fell faster.
A major factor is the very high (I would suggest absurd) weighting to rents in the US inflation index. Rental inflation is slow to react to changes, not least because the difficulties of measurement add delays. By contrast, the eurozone inflation index has a much lower weight on rents, allowing a much more rapid decline (Figure 3).
We need sustained low inflation for interest rates to be cut – it is not enough for the year-on-year headline figure to decline just because of base effects. Wage growth is the key to keeping inflation low.
Figure 3: Core inflation is falling fast
Source: Columbia Threadneedle Investments and Bloomberg as at 23 May 2024
Wage inflation is critical to other side of the Goldilocks scenario
The key to inflation is wages – both in terms of costs and demand. Here we see a virtuous spiral as falling inflation allows a flexible labour market to moderate wage demands as real incomes recover.
Wage inflation in the US has flattened out, staying above the 4% level, and there is a long wait for the next quarterly Employment Cost Index release. That, together with economic resilience, is why the Fed has backtracked on rate cuts. However, I think that there is a good chance that wage growth resumes its downward trend, with the expansion of the labour force (driven by a surge of unauthorised migration) removing some of the shortages that were causing wage inflation.
The latest figures in the eurozone also disappointed, with wage growth holding above 4%. But we expect the European Central Bank to look through this recent strength because its own research highlighted a new survey of wage growth which shows a declining trend (Figure 4). As a consequence, we expect it to go ahead with its planned interest rate cut in June, leapfrogging to the front of the queue.
Figure 4: Euro area, indicator of negotiated wages % year-on-year
Source: Columbia Threadneedle Investments and Bloomberg as at 23 May 2024
Markets
The combination of continued economic growth with falling inflation and interest rates is positive for capital markets. While we think that government bonds offer good value, we also like equities.
Equities appear expensive on most valuation measures. However, expensive equity markets tend to only get more expensive in favourable economic conditions. Any significant valuation correction usually waits until the next recession and I do not see any chance of a recession in the next year.
Current high equity valuations also reflect the “Magnificent 7” of US tech-driven mega-caps. These companies – Alphabet, Amazon, Apple, Microsoft, Meta, Nvidia and Tesla – have overall delivered higher profit margins, even as the rest of the market struggled.
The gold price also decoupled from its inverse relationship with real bond yields since the invasion of Ukraine. This is likely linked to the freezing of Russian assets, including those of 2,000 private individuals and entities prompting a broad shift to alternative safe havens for wealth. I have been drawing attention to this all year and, following sharp gains, gold now appears overbought in the short term.
Overall, we are closer to Goldilocks than seemed likely a year ago with both inflation and recessions risks declining.
