Stock Markets, Goldilocks and the three ‘Bears’ to watch out for

Two friends following market events of the week got into an interesting conversation.

Ram: After all the progress Central Banks globally have made to stem inflation over the last year, it now looks like the rally in crude oil can play spoilsport.

Veena: Yes, elevated crude oil price is a key risk to watch out for although there are many other components that drive inflation. In fact, recently, brokerage firm Jefferies noted that the Goldilocks position for Indian equities is under threat due to this and a few other factors.

Ram: What is Goldilocks position? Never heard of that word other than in the fairy tale!

Veena: Haha, yes, the analogy is drawn from the fairy tale. It refers to a scenario where something is in a sweet spot with all variables optimally positioned. An economy that is neither running too hot nor too cold, but at an ideal pace. A steady-growing economy with moderate inflation and low unemployment rate can be optimal for long-term growth and represents a Goldilocks economy.

Ram: I thought higher the economic growth, the better it is!

Veena: Oh yes, it is, but only if other macro economic variables like inflation too are not driven higher by it. For example, if the economy is growing too fast beyond potential, then inflationary threats come to the fore. Central Banks in such situations are constrained to increase interest rates to slow the economy to avert long-term risks to growth. History is loaded with painful lessons of economic busts after inflationary spikes.

On the contrary, if the economy is too slow, then threat of deflation surfaces. Many economists consider deflation a bigger threat than inflation as prolonged deflation can cause more severe downturns.

Ram: How?

Veena: In an economy impacted by deflation, buyers postpone decisions to purchase goods and services in anticipation of lower prices later. This, in itself, can accentuate the economic slowdown into a downward spiral.

Ram: Hmm…I get it now, why too hot or too cold an economy are both risks.

Veena: Yes, many a time it is slow and steady that wins the race. You may have noticed that many of the best-performing stocks over the last decade are from boring businesses that grew at a moderate pace, but consistently, over the last 10 years.

So whether it is economics or stocks, consistency matters more.

• Also read: India is optimistic, positive about its future growth, says FM Sitharaman

Ram: Ok, is India’s Goldilocks situation under threat now?

Veena: A little bit…the three ‘bears’ posing risk to Indian economy are crude, monsoons, and global macros. All three can put pressure on the RBI to remain vigilant on inflation for a long time. Erratic monsoons and its impact on vegetable prices, and derivative impacts of higher crude prices are already putting pressure on inflation. Further, with global central banks indicating their intention to keep rates higher for longer and bond yields spiking in developed countries, the pressure may be on RBI to keep rates at current levels.

In fact, last week, the RBI increased FY24 inflation forecast to 5.4 per cent from 5.1 per cent, reflecting some of these threats.

While we can say with our current economic growth and inflation, we are still in the Goldilocks situation, the upward pressure on inflation poses some risk. We will have to wait and see how this plays out.

Ram: Hmm, ok, so what does this mean for stocks?

Veena: Typically Goldilocks periods in economic growth have been excellent for corporate profits and, thereby, stocks. For example, the period 2015 to 2019 is considered a Goldilocks period in global economy, with moderate growth and inflation. Globally, stocks did well in this period. In India, the recent period apart, the longest such phase was between FY03 and FY07, which was a boom period for corporate profits and stocks as well. So, yes, Goldilocks periods are very good for stocks. But here is the catch – with economy always playing out in cycles, Goldilocks gives way to the ‘bear’ at some point in time.

The risk that investors need to keep an eye on, now, is threats to our Goldilocks economy. With indices like Nifty 50 trading at a premium to historical average, they are at present reflecting continuation of the Goldilocks economy.

COMMENT NOW