Investors often talk about a ‘Goldilocks’ scenario in markets, with three risks – or three bears – creating challenges with respect to growth, inflation and policy.
Markets crave a scenario that is just right, with inflation neither too hot nor too cold, economic growth neither too high or too low, and policy neither too aggressive nor too weak.
The last few years have seen an oscillation between these factors, with a contagion effect often spilling over to force risks to emerge elsewhere.
Excessively aggressive policy during the pandemic, for example, led to large increases in financial liquidity, ultimately resulting in rising inflation risk.
More recently, President Trump’s Liberation Day tariff announcements in April introduced a heightened level of risk to the growth outlook, with concerns at one point rising to the level of a potential US recession.
A string of trade deal announcements between the US and its major trade partners has helped ease negative sentiment around the growth outlook, reassuring investors and reducing fears of an imminent recession.
The inflation outlook is a little more nuanced, though overall the picture has materially improved in the last few years.
Inflation in the Eurozone, where we have already seen a string of interest rate cuts, is back down to more comfortable levels, hovering around the 2% range.
In the US, meanwhile, has inflation running a little higher but recent weaking in the labour market has opened the door to a fresh round of interest rate cuts which is likely to be positive for equity and bond markets.
The UK, however, is still something of an outlier when it comes to inflation risk, with the headline rate at 3.8% nearly double the Bank of England’s (BoE) 2% target. With persistent inflationary pressures, particularly strong wage growth, the BoE faces greater constraints in easing policy. As a result, cutting interest rates in the UK is still a more complex and potentially inflationary move.
This brings us to policy risk, an area where our concerns have been building for some time. Fiscal sustainability has become a major topic in the market, with many developed countries experiencing a ballooning debt interest bill and increasingly unsustainable debt-to-GDP ratios.
The UK and France are particularly vulnerable to these pressures, as reflected in the significant rise in their borrowing costs year to date
These risks are still present and could well re-emerge in the coming months as France’s new Prime Minister and the UK’s Chancellor attempt to forge a new path forward.
Beyond government borrowing, the key wildcard in the policy risk landscape remains President Trump. Ongoing questions around the independence of the U.S. central bank – the Federal Reserve, raise concerns that policy risk could spill over into broader areas of the market, introducing fresh sources of volatility.
President Trump’s unpredictable presence on the global stage adds further uncertainty. His leadership could just as easily usher in a period of prolonged global stability as it could trigger renewed geopolitical tensions.
With growth and inflation – two of the three ‘bears’ threatening a Goldilocks scenario – showing signs of subsiding, markets may be on a more constructive path from here. That is, of course, if policy risks stay contained.
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