Stockwatch: Goldilocks at risk from the bears

The concept of a "Goldilocks economy" I posited last month, i.e. one that is neither too hot nor too cold, has been a chief influence on stockmarkets entertaining record highs. The sense being that the global economy is strong enough to avoid a spate of company profit warnings, but not so strong that central banks begin raising interest rates.

There is a self-reinforcing bias to this uptrend, while investors face no real alternatives for yield; a sense that annual dividend income of about 4% is there for the taking and cash deposits are a dumb cause. The scenario can continue for so long as dividends don't get compromised by weaker earnings, and an instinct to "buy the dips" fends off a breakdown in equity values. But mind the risks lurking which could strike at this consensus.

Twin positives for continental Europe

Deflationary fears that gripped markets in the New Year have eased as oil and other commodity prices found relative stability. Moreover, and defying expectations, continental Europe has released better-than-expected economic data - e.g. factory output hitting a four-year high. This coincides with the European Central Bank now committed to 18 months of quantitative easing, and investors are hard-wired to envisage as good for stockmarkets after the global rally since 2009.

It's a potent combination explaining why markets are barely concerned by the fraught negotiations over Greece's debt. EU officials cannot seem to face the reality of major debt write-downs being required for Greece to achieve a stable financial base; hence this problem will rumble on. Investors are correct, however, to sense a back-stop: how European and American political elite want to keep Greece in the European fold at virtually any cost, with Russia now a threat.

Also, the European financial system's defence walls are - allegedly - more robust to withstand a Greek exit from the euro, compared say with 2012. European shares will always be exposed to wider economic and political risks, and proof ultimately depends on how corporate profits evolve. But Europe is looking more positive than earlier this year.

Increasing focus on the UK general election

The 18 March budget has been received well and the UK 2015 growth forecast revised up slightly by the Office for Budget Responsibility, from 2.4% to 2.5% with 2016 expected to see a rise from 2.2% to 2.3% - for what such forecasts are worth. The benign outlook can easily change in a few weeks, say if Scottish Nationalists make it awkward for the Conservatives to form another coalition government. Voters' reactions to the budget imply a Conservative majority looks a tad less difficult to achieve, and the first-past-the-post system is likely to compromise UKIP to some degree. But there remains a chief risk the right-wing vote gets split to an extent able to let Labour into power.

The UK companies theme continues resilient with no discernible trend in profit warnings able to compromise dividends - except occasional reality checks such as Morrisons capitulating to halve its dividend outlook. The market had anyway anticipated this so the stock barely flinched; indeed, it has recently firmed amid expectations of a turnaround under a new chief executive. Yet with foodstuffs remaining under deflationary pressure and the UK over-supplied with supermarkets, Morrisons' forward price/earnings (P/E) multiple near 20 times reflects the market's optimistic tone.

Danger lurking behind a US interest rate rise

With mixed data emanating from the US it is a conundrum to guess the interest rate trend - and even more so, what expectations are factored in. Underlying growth of 3.3% with unemployment thought likely to drop below 5% later this year, raise the fear of wage pressures leading to inflation hence a pre-emptive rise in interest rates. But February's durable goods orders fell for a sixth consecutive month, i.e. economic growth slowed sharply, in part due to bad weather.

Consequently the US Federal Reserve's message has been overall dovish on raising rates, despite the significance of dropping the word "patient" as if to allow action when judged fit. Interpretation isn’t helped by contrasting views among Fed officials, e.g. Charles Evans of the Chicago Fed has warned that global uncertainty is the biggest risk to the US economy therefore interest rates should stay low until 2016.

Meanwhile, James Bullard of the St Louis Fed has cautioned how investors are being over-complacent about the likely pace of monetary tightening; likewise the San Francisco Fed's John Williams saying that by mid-year it will be necessary to discuss raising rates. The founder of Bridgewater Associates, a $165 billion (£110 billion) hedge fund, has warned the Fed risks a 1937-style crash when it starts raising interest rates. Similarly, as now, it had printed money for years to help the US economy recover from the 1929 crash, but as soon as rates went up the stockmarket bubble burst.

The dilemma has much wider significance in a modern inter-connected world, with an estimated $9 trillion of dollar-denominated debt outside the US - liable to cause problems for developing countries. Dollar strength exacerbates the burden for those exposed to dollar-based debt, with any interest rate rise set to compound this. There is a real risk of a "moment of truth" when investors twig how the Fed and other central banks are caught in a dilemma after years of loose monetary policy. Add the current extent of financial derivatives - nearly 10 times the value of global equities, some 80% based on interest rates - and the potential for upset is clear.

Bloated Chinese stockmarket: P/E's over 100 times

An inscrutable aspect of Chinese finance is the communist authorities muddling through more capably than their capitalist counterparts - so far, avoiding crises despite evident signs of excess. These have moved on from uninhabited ghost-towns to the financial markets where some 700 Chinese stocks now trade on P/E multiples over 100 times.

If economic laws apply universally then when will such equity values "revert to the mean" (average) over time? The situation is reminiscent of the Japanese stockmarket in the mid-1980's when P/E's similarly soared to silly levels - attempted justified at the time by Japan's unique culture and economy. Yet the 1987 slump discredited all that, with Japan proceeding to suffer a chronic deep recession. Not to try and draw a direct comparison, but the big current risk is Chinese stocks' having soared on liquidity - specially more individuals’ borrowing - than much real improvement in corporate fundamentals or the wider economy. China was the world's best-performing stockmarket in 2014 and prices have nearly doubled in less than a year to the highest level since May 2008.

Meanwhile, the latest economic statistics are disappointing: Chinese rail freight has slumped by 9.1% year-on-year; the manufacturing purchasing managers' index is down to 49.2 (i.e. below 50, implying contraction) the lowest in 11 months; and an employment sub-index has fallen to its lowest since 2008. Japanese data has also suggested its slowly recovering economy could be losing momentum, versus the stockmarket trading at a 15-year high. Scope for an inflection point between sentiment and fundamentals certainly exists in these Far Eastern markets.

So don't let the bullish consensus for global equities let you lapse into unawares; recalling how the Goldilocks story involved bears too.