Goldilocks Economy – Too Hot, But Cooling

July 9, 2021 – Economist David Shulman is credited for coining the term ‘Goldilocks Economy’ – which refers to an economy that is “hot enough for profit growth, but cool enough to keep the Fed from hiking interest rates”. We are continuing to experience this trend as we hit the mid-point of 2021, and several months into the post-coronavirus economic recovery period.

The U.S. economy has delivered on expectations for the post-pandemic reopening. Travel, hospitality, and live entertainment are among many industries enjoying a comeback. U.S. stocks as measured by the S&P 500 registered a gain that would be considered a full year’s return in other times, rising 8.55% during the second quarter. This marked a new record high, and the fifth quarter in a row of greater than 5% gains.

Concerns over inflation have been the subject of much attention during the quarter. The 2021 full-year inflation rate is predicted to be around 3% at this time. Supply chain disruption has been the primary cause of higher prices for goods. Higher demand from consumers and businesses have also contributed to price increases. While inflation concerns are likely to linger, these current pressures are expected to be temporary, and the headline attention given those concerns has already begun to wane.

The potential for higher wages is a longer-lasting factor. This fall will reveal valuable data on employment and wages. With the presumed end of enhanced unemployment benefits and with children back in classrooms, it will be telling whether the labor shortage is relieved. If not, this adds to the likelihood of persistent inflation. However, sustained, problematic inflation is anything but certain since there are deflationary forces in the economy as well.

The most dynamic phase of the post-pandemic recovery peaked in the second quarter.  Further increases in inflation, economic growth, longer-term interest rates, and stock market gains are all still likely from current levels, but at a slower pace.

Crypto assets including Bitcoin and other cryptocurrencies were in the spotlight this quarter. Investor interest and media coverage were a result of the huge price increases this spring due mostly to trading momentum. This most recent rise and fall demonstrated again that cryptocurrencies are not yet a reliable store of value, means of payment, or hedge against inflation. What these coins do well, given their limited supply, is offer a vehicle for price speculation. The enduring value of crypto assets is in the underlying blockchain technologies with their decentralized record-keeping systems. These technologies have great potential in the areas of supply chain management, smart contracts, financial services, and many other applications yet to come. We are not currently advising or adding an allocation to digital assets in client portfolios, but we are monitoring developments in the space as it continues to evolve. Several fund providers have submitted applications to the SEC for Exchange Traded Funds (ETFs) based on digital assets. Approval of these ETFs would be a significant step toward the wider adoption of these assets.

U.S. stock prices reflect the strong economic recovery. We view prices as fairly valued, neither overpriced nor underpriced for this high-growth, market friendly environment. As usual, there are still areas of opportunity and room for gains in most sectors. While there is no clear leadership in the market, we have seen the outperformance of last year’s high-growth stocks give way to economically-sensitive value stocks. More recently, these stocks have slowed, while some traditional growth areas have regained momentum. These recent rotations among style and sector performance provide an example of the importance of portfolio diversification within the equity allocation. The disparity in returns also gives us an opportunity to rebalance portfolios.

In foreign markets, we expect corporate profits to strengthen. Both developed markets and emerging markets stocks are benefiting from rising global economic growth. Higher interest rates and commodity prices are particularly helpful to emerging markets. In recent weeks, the U.S. dollar has again strengthened and is now higher for the year. A stronger dollar makes foreign profits less valuable in dollar terms, which can be a drag on returns for U.S. investors in foreign denominated stocks.

We continue to expect bonds to have lower returns than normal due to historically low interest rates. The benchmark 10-Year Treasury Note ended the quarter at a yield of 1.44%, down from 1.75% on March 31^st, and up from 0.91% at the start of the year, reflecting a lessening of inflation fears since March. We view current bond yields as too low to be consistent with a strengthening economy, given the increasing supply of bonds coming into the market and the risk of inflation. Even in this low-rate environment, a fixed-income allocation is important for most portfolios. We prefer to build core portfolios of individual municipal bonds or high-quality taxable bonds both with maturities shorter than a neutral benchmark position. For diversification and added yield, we also supplement these with small allocations of lower rated bonds, convertible bonds, preferred stock, and specialty bond funds.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.