The Goldilocks Economy and Bear Markets

Sorry for the pun (hopefully you have heard of The Story of Goldilocks and the Three Bears), but as we get near year-end it seemed opportune to discuss the current market sentiment and our future outlook.

The U.S. economy is currently in a sweet spot, or a Goldilocks effect, of not being too hot to spur rapid inflation but not too cold to cause a recession.  A bear market, loosely defined as a drop of over 20%, and a recession, two consecutive quarters of negative GDP growth, seem a long way off.

There are a few factors that warrant monitoring:

Loose Fiscal Policy – U.S. GDP in a range of 2-3% has historically been the sweet spot of accommodative monetary policy and low inflation.  An overextension of fiscal stimulus may push the economy too fast forcing the Fed to tighten their policy.  The ensuing run in inflation would lead to tightening in the monetary policy regime, often a key factor leading up to a recession.

Black Swans – Unforeseeable events such as geopolitical tensions do exist but beyond a short-term negative reaction the market tends to bounce back rather swiftly.

The current market environment consists of historically low interest rates, stable oil prices, 10-year highs in global manufacturing indices, low unemployment, and the absence of a bubble within the financial system.

Given these views, our belief is the likelihood of a recession or a bear market is very low over the next year.  Any pullbacks in the market can be seen as an opportunity to add equity exposure.

Risks

  • Extensive fiscal stimulus could lead to the U.S. economy overheating High impact; low probability
  • Continued political uncertainty surrounding the year-end fiscal cliff High impact; low probability
  • Escalating tensions with North Korea High impact; low probability
  • China suffers a prolonged economic recession High Impact; medium probability

Investment Themes

  • Stocks continue to look more attractive over fixed income given strong earnings growth and slowly rising rates
  • Credit looks more attractive than Treasuries, but a diversified approach to investing in fixed income is important given Fed tightening
  • International equities are favored over domestic equities given stronger growth prospects abroad and favorable currency returns

Written by:  Antonio Belmonte, CFA

*These are the opinions of Antonio Belmonte and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice.  Past performance is no guarantee of future results.  Diversification and asset allocation strategies do not assure profit or protect against loss.