Goldilocks, or the worst of all possible worlds?

The phrase “Goldilocks economy” has been around for decades. It’s used to describe a period when the economy is neither too hot to generate additional inflation, nor too cold to qualify as contractionary. In other words, the porridge is just right. A very optimistic read of last Thursday’s first quarter GDP release might have convinced some of the more, uh, upbeat among us to conclude that the US economy is inching its way back toward that fabled zone where growth is slow (but not uncomfortably so) where prices are well-behaved and whence the Fed can safely return to its peaceful hibernation¹.

Here's how that line of reasoning might run: at a rate of 1.1%, real GDP growth during the first quarter of 2023 was slower than it has been since the second quarter of last year, when it famously declined for a second quarter in a row. Last quarter’s 1.1% advance was lower than economists’ expectations, was comfortably below trend, and was also below “potential GDP” (which is the Congressional Budget Office’s best guess as to how much the US economy is capable of growing without overheating.) Meanwhile, even if 1.1% growth isn’t necessarily enough to qualify as boom times, at least there haven’t been any massive layoffs of the type that would make the upcoming Memorial Day barbecue in your neighborhood a depressing opportunity to cross-network ineffectively with all the poor schlubs who have suddenly found themselves out of work. So growth is slow enough to eventually tame inflation, but also strong enough to prevent the job-killing recession that many now view as almost inevitable.

But to maintain such an optimistic interpretation of last week’s GDP growth number, you’d have to get comfortable with one unfortunate fact: buried inside that same GDP report was also news that core inflation – represented here by so-called “core PCE” and one of the Fed’s preferred metrics of price pressures – rose 4.9%. That’s an acceleration from last quarter, is still miles away from the Fed’s official 2% target and was as disappointing relative to economists’ estimates as the softening GDP number might have been reassuring.

Now its not impossible to reconcile reaccelerating inflation with the Goldilocks world view – you just have to try really hard and make a few leaps of faith to do it. Specifically, you have to bank on the fact that the Fed’s efforts almost always tend to cool the economy first, then tame inflation second. In other words, there’s a “long and variable lag” between when the Fed starts raising rates and when it finally gets control of prices. Sandwiched in between those two is a period when economic growth inevitably slows (but doesn’t necessarily have to turn negative) – which is exactly where those who see Goldilocks in the window of last quarter’s GDP numbers must think the US economy currently resides. In other words, you simply have to trust that the tightening the Fed has already put in the pipes (or will eventually still put in the pipes, given that even among the optimists the overwhelming consensus for this week’s FOMC meeting is another quarter-point increase...) is exactly the right amount to both control prices and keep the economy from collapsing in on itself.

So that’s one way to interpret Wednesday’s GDP numbers. Another, far less optimistic way is to see it as the worst of all possible worlds, (which, incidentally, is exactly how at least one headline announcing Thursday’s GDP release described it².) That interpretation sees weaker-than-expected, below-potential GDP growth as a harbinger of things to come (barbeque- vibe-destroying layoffs and a potentially deep recession among them,) while at the same time pointing to the uncomfortably high inflation number imbedded within it as evidence that inflation will be around a lot longer than most people realize, and that the Fed’s job is therefore still far from over. To fully reconcile that view, you simply have to take a different leap of faith – namely, that the Fed remains fully and unflinchingly committed to its 2% target and that it’s tendency to overshoot the mark when tightening policy will repeat itself this time around.

Which of these two views you find yourself closer to probably says a lot about your personality. (Are you a “glass half full” kinda person, or the other type?) But for what it's worth, markets seemed to tend more toward the Goldilocks/glass-half-full mindset last week: while nobody seemed willing to come right out and say it, market performance speaks louder than words and Thursday was the best day for US equities in an otherwise “meh” kind of week. At a minimum, that tells you that markets weren’t at all put off by a slowing economy and reaccelerating inflation contained in the BEA’s report, which a “worst of all possible worlds” interpretation might otherwise have required.

If you’ve been reading this perspective for a while, you probably know where my head is at. (Here’s a hint: I don’t believe in fairy tales and am more inclined to believe that The Three Bears would’ve simply eaten Goldilocks and been done with all her nonsense than they would be let her off scot-free.) But I’m also not quite as rampantly bearish on the economy as a “worst of all possible worlds” mindset would imply and am at least willing to entertain the idea that a more optimistic interpretation might be the correct one. If nothing else, my fellow pessimists and I are required to at least acknowledge that a valid, sincere debate exists surrounding the future direction of growth – even if the Fed by necessity remains squarely in inflation-fighting mode.

But here’s one of the more surprising things about the current environment that I still can’t fully reconcile to my otherwise mostly-bearish argument: at this stage in the cycle, corporate earnings should be helping settle the debate by either accelerating (hello, Goldilocks!) or collapsing (oh no, the bears are home!) So far, they haven’t really done either. Last week there was plenty of red meat to satisfy both sides, whether it was the industrial and transport sectors’ tendency to miss estimates and lower guidance, or a few big players in tech sector, who tended to beat estimates and raise guidance. And when viewed collectively, first quarter earnings season has been anything but a disaster so far, with fewer S&P 500 companies missing estimates than at any point in the last year and a half³. Sure, those earnings estimates had been set meaningfully lower before the fact (and earnings growth is now negative for a second consecutive quarter,) but if you believe that markets take in and respond to that kind of information efficiently, then the ability of companies to leap over the recently-lowered bar puts more of a believable spin on the stock market’s resilience in the face of significant macroeconomic uncertainty than I for one might be willing to grant.

Economic events

May 1-5

Monday: ISM/PMI manufacturing; earnings: ON, RIG
Tuesday: JOLTS; earnings: AMD, F, BP, SBUX
Wednesday: Fed decision, ADP payrolls, ISM/PMI services; earnings: n=450+ Thursday: Challenger job cuts, weekly jobless claims; earnings: AAPL, n= 580+ Friday: Non-farm payrolls; earnings: BRK

Okay, odds-and-ends time: here is a quick recap of a few of the more important economic releases that our deep dive into the Goldilocks debate prevented us from covering. Let’s start with consumer confidence: on Friday, the University of Michigan’s final read on consumer sentiment for April showed that consumer attitudes remained mostly stable⁴. The Conference Board’s view was slightly less upbeat and remains more or less consistent with a looming recession⁵, but the widening gap between its forward-looking component and consumers’ assessment of current conditions suggests that we’re not quite there.

Meanwhile, all three regional Fed manufacturing reports (Dallas⁶, Richmond⁷ and Kansas City⁸) had a lot more in common with Philly’s big miss during the prior week than Empire State’s upside surprise, suggesting that the manufacturing sector is still bleeding despite a few recent reports suggesting otherwise. And finally, with respect to housing, pending home sales took a big leg down by falling 5.2%⁹, their first decline since November and a big contrast to new home sales, which advanced significantly¹⁰. Prices, though, have remained firm even as volumes wavered behind continued availability issues¹¹. Add that to the big pile of contradictions that increasingly seem to define the current macro environment.

So in closing, feel free to take up whichever the side of the Goldilocks debate that feels most comfortable to you – there are plenty of reasons to believe either side if you’re only willing to look hard enough. But also, try to remember this: at the end of the fable, the bears eventually came home and were none too happy when they found Goldilocks sleeping in their beds and eating their food.

What to watch this week

We’ve reached the point in first quarter earnings season where there are almost too many companies reporting to provide any kind of preview that’s even remotely helpful. In the past, I’ve been tempted to call this the “season of also-rans”, when most of the headline-grabbing companies have already reported and earnings season becomes mostly about broad trends, sheer numbers and an occasional anecdote or two. While that’s never quite the case (honestly, it’s always been just more of a convenient device to keep this write-up from stretching to thirty pages, single-spaced,) this time around it’s even less true for no other reason than the fact that Apple, the largest company in the world by market cap and a splendid proxy for global consumer demand, reports on Thursday.

There are a handful of other potentially eye-catching reports scheduled for this week, including Starbucks (another consumer bellwether that could provide an interesting peek into the minds of the discretionary purchaser as the economy threatens to weaken,) as well as Berkshire Hathaway – a company managed by investment icon Warren Buffet and with tentacles in so many diverse business across the economy so as to seem like a tiny little US economy all unto itself. These, together with a handful of semiconductor and energy companies and literally a thousand others, are all quite capable of capturing the market’s attention and altering the narrative that a so-far, so-good first quarter earnings season has already provided.

But it's still the case that there are simply too many companies reporting this week (more than 400 on Wednesday and nearly 600 on Thursday) to make much sense of things before the fact. Good thing, then, that there should be plenty to think about outside the pressure cooker of quarterly earnings. Let’s start with the Fed: the FOMC’s latest scheduled meeting begins on Tuesday with a decision on rates expected Wednesday afternoon. As mentioned above, consensus is looking for another quarter-point increase, and anything on either side of that would be seen as surprising. Far more controversial, though, is whether that increase will be the last one for a while, which makes the statement itself and the post-decision press conference the real show on Wednesday.

If that weren’t enough, it’s also payrolls week. As usual, the fun begins on Tuesday with the so-called JOLTS report detailing how many open positions there are across the US economy, as well as who’s leaving their jobs and why. Then on Wednesday we’ll get ADP’s guess at how many jobs were added to the economy last month, together with the rich and robust pay insights data that the payroll processor has recently begun highlighting alongside their estimate of payrolls. Thursday brings the Challenger, Gray and Christmas layoff report – deserving of even more attention than usual given fears that the layoff wave is now broadening out from its origin as a tech-sector-only phenomenon into other areas of the economy as well. Then on Friday, the main event of “the big burrito,” the Bureau of Labor Statistics’ employment situation report and its look at unemployment, non-farm payroll growth, labor force participation and all the goodies that come with it. Suffice to say that at least some kind of softness in any or all of these reports would probably be viewed as welcome given the persistent tightness of the US labor market and all the bad things that come along with it.

Finally, we’ll also get final Purchasing Manager’s Indices for the month of April from both the Institute of Supply Management and S&P Global this week. These and other like-minded surveys have been unusually volatile in recent months, including broad disagreement among the various regional Fed manufacturing reports such as Empire State and Philly, as well as last month’s “flash” PMIs suggesting that both manufacturing and services were now growing again. These surveys will eventually have to come to some kind of agreement, and wherever they land will ultimately answer the question of who to believe, Goldilocks or the bears.