Opinion: The Goldilocks market is dead, says Roubini


NEW YORK (Project Syndicate) —How will the global economy and markets develop over the next year? Four scenarios could follow the “slight stagflation” of recent months.

The recovery in the first half of 2021 has recently given way to a marked slowdown in growth and a surge in inflation well above the central banks’ 2% target, due to the effects of the delta variant, supply bottlenecks in goods and labor markets, and shortages of some products, intermediate inputs, finished products and labor. TMUBMUSD10Y bond yields,
1.317%
have fallen in recent months and the recent correction in the SPX equity markets,
+ 0.23%
has been modest so far, perhaps reflecting the hope that the slight stagflation will prove temporary.

Four possible scenarios

The four scenarios depend on whether growth accelerates or decelerates and whether inflation remains higher or slows for a long time. Wall Street analysts and most policymakers are anticipating a “Goldilocks” scenario of stronger growth and moderation of inflation in line with the central banks’ 2% target. According to this view, the recent episode of stagflation is largely due to the impact of the delta variant. Once it wears off, so will supply bottlenecks, provided new virulent variants do not emerge. Growth would then accelerate while inflation would fall.

For markets, this would represent a resumption of the “trade reflation” outlook from the start of the year, as it was hoped that stronger growth would support higher earnings and even higher stock prices.

Faced with a debt trap and persistently above target inflation, they will almost certainly weaken and fall behind, even if fiscal policies remain too loose.

In this optimistic scenario, inflation would subside, keeping inflation expectations anchored around 2%, bond yields would gradually rise in line with real interest rates, and central banks would be able to gradually reduce quantitative easing without shake up the stock or bond markets. In equities, there would be a rotation from the United States to foreign markets (Europe, Japan and emerging markets) and from growth, technology and defensive stocks to cyclical and value stocks.

The second scenario involves “overheating”. Here, growth would accelerate as supply bottlenecks are lifted, but inflation would remain stubbornly higher, as its causes would not be temporary. With unspent savings and pent-up demand already high, the pursuit of ultra-accommodative monetary and fiscal policies would further stimulate aggregate demand. The resulting growth would be associated with persistent inflation above target, disproving central banks’ belief that price increases are only temporary.

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The market’s response to such overheating would then depend on the reaction of central banks. If policymakers stay on the sidelines, stock markets could continue to rise for some time as real bond yields remain low. But the ensuing rise in inflation expectations would eventually boost nominal and even real bond yields as inflation risk premiums rise, forcing equities to correct. Alternatively, if central banks become hawkish and start fighting inflation, real rates would rise, pushing bond yields up and, again, forcing a larger correction in equities.

Stagflation in progress

A third scenario is continued stagflation, with high inflation and much slower growth over the medium term. In this case, inflation would continue to be fueled by accommodating monetary, credit and fiscal policies. Central banks, trapped in debt by high public and private debt ratios, would find it difficult to normalize rates without triggering a financial market crash.

In addition, a host of persistent negative supply shocks over the medium term could dampen growth over time and drive up production costs, which would increase inflationary pressure. As I have noted previously, such shocks could come from de-globalization and rising protectionism, balkanization of global supply chains, aging populations in developing and emerging economies, migration restrictions, “ Sino-American decoupling of the effects of climate change on commodity prices, pandemics, cyber warfare and the backlash against income and wealth inequalities.

In this scenario, nominal bond yields would rise much more as inflation expectations lose their anchor. And real yields would also be higher (even if central banks were to lag behind), as rapid and volatile price growth would increase risk premiums on longer-term bonds. Under these conditions, equity markets would be poised for a sharp correction, potentially into bearish territory (reflecting a decline of at least 20% from their last peak).

The last scenario would be that of a slowdown in growth. Weaker aggregate demand would prove not only to be a transitory fear, but a harbinger of the new normal, especially if monetary and fiscal stimulus are withdrawn too soon. In this case, weaker aggregate demand and slower growth would lead to lower inflation, stocks would correct to reflect weaker growth prospects, and bond yields would continue to fall (as real yields and expectations of inflation would be lower).

Most likely scenario

Which of these four scenarios is most likely?

While most market analysts and policymakers have pushed the Goldilocks scenario, I fear the overheating scenario is no longer salient. Given today’s lax monetary, fiscal and credit policies, the fading of the delta variant and associated supply bottlenecks will cause growth to overheat and leave central banks stuck between. the hammer and the anvil.

Faced with a debt trap and persistently above target inflation, they will almost certainly weaken and fall behind, even if fiscal policies remain too loose.

But in the medium term, as various lingering negative supply shocks hit the global economy, we could end up with stagflation or overheating much worse than mild stagflation: total stagflation with much lower growth and inflation. higher. The temptation to reduce the real value of large nominal fixed-rate debt ratios would lead central banks to adjust to inflation, rather than fighting it and risking an economic and stock market crash.

But debt ratios (both private and public) today are significantly higher than they were in the 1970s, during a period of stagflation. Public and private officials with too much debt and much lower incomes will face insolvency once inflation risk premiums push real interest rates up, paving the way for debt crises stagflationist against which I warned.

The Panglossian scenario that is currently embedded in the financial markets could eventually become a pipe dream. Rather than focusing on Goldilocks, economic watchers should remember Cassandra, whose warnings were ignored until it was too late.

Nouriel Roubini, Professor Emeritus at the Stern School of Business at New York University, is Chief Economist at Atlas Capital Team and CEO of Roubini Macro Associates.

This comment was posted with permission from Project Syndicate – Goldilocks is Dying

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