Citi Personal Wealth Management

Goldilocks Can’t
Find the Right Temperature

Market Reaction: May 12, 2021

Key Thoughts

In the classic fairy tale, a little girl named Goldilocks wandered upon a house in the forest. After knocking, she decided to walk in and quickly tried the three bowls of porridge on the kitchen table because she was hungry. The first bowl was too hot, the second bowl was too cold, but the third bowl was just right. This classic tale reminds me of investors today.

Right now, the bowl seems a bit too hot for investors’ liking. U.S. real gross domestic product (GDP) grew by an annualized rate of 6.4% in the first quarter of 2021, U.S. job openings surged to a record high of 8.1 million jobs in March, and the Consumer Price Index (CPI) surged from 2.6% year-on-year in March to 4.2% year-on-year in the April print. According to small businesses, a record 44.0% of respondents said that they were unable to fill open positions and some 31.0% said they have boosted worker compensation.

This has ignited a debate about whether or not enhanced unemployment benefits are restraining job growth with the economy adding just 266,000 jobs in March (when expectations were for 1 million jobs to be added). We are hesitant to make that claim based upon one month’s data, but there are still some 6.8 million gig workers receiving unemployment benefits through the Pandemic Unemployment Assistance (PUA) program and approximately 5.0 million workers receiving extended unemployment benefits. It is possible that workers who are reluctant to return could temporarily drive up wages as companies compete for qualified employees. Though with the extended benefits are set to expire on September 4, 2021, such a phenomenon seems unlikely to be long-lasting. Particularly as a growing number of states are rejecting increased benefits and President Biden is saying that anyone collecting unemployment who is offered a “suitable job” must take that job or lose unemployment benefits. Though it is difficult to see how that would be enforced.

Investors are essentially debating two topics:

  1. Is the economy at risk of overheating?
  2. Is inflation going to be a significant problem?

It is difficult to answer these two questions, but we think there are a few charts that are telling. The first chart is the Federal Reserve’s Senior Loan Officer’s Survey of Credit Conditions which points to continued economic growth in the quarters ahead (see figure 1). The second chart is an ISM model against several metrics of inflation (see figure 2).

Figure 1. Banks Tightening Credit Conditions for Commercial and Industrial Loans vs. Real GDP
Figure 1: Banks Tightening Credit Conditions for Commercial and Industrial Loans vs. Real GDP
This line chart shows Federal Reserve’s Senior Loan Officer’s Survey of Credit Conditions which points to continued economic growth in the quarters ahead.
Sources: Bloomberg and Citi U.S. Wealth Management as of 2Q, 2021. Note: Shaded regions denote periods of recession.
Figure 2. ISM Model vs. U.S. Inflation
Figure 2: ISM Model vs. U.S. Inflation
This line chart is an ISM model against several metrics of inflation and suggests the April print may be an overshoot and the data may start to moderate some over time.
Sources: Bloomberg and Citi U.S. Wealth Management as of April 2021.

These charts suggest to us that the bond market might be underestimating the strength and longevity of the economic rebound and overestimating the intermediate rate of inflation. With core CPI inflation jumping to 3.0%, for at least a brief period, a 2.0% 10-year U.S. Treasury yield by year-end seems more than reasonable. Though our ISM model suggests the April print may be an overshoot and the data may start to moderate some over time. Perhaps a 10-year U.S. Treasury yield in the range of 2.5% over the next couple of years of expansion is feasible. See our CIO Bulletin: When Zero is Not Enough and Global Strategy Bulletin: COVID Distortions Boost Inflation. The Long-Term is Less Troubling for a more detailed discussion.

Importantly, we do not see higher interest rates or inflation as causing a significant bear market in U.S. stocks. Traditionally, bear markets are caused by either fears of or an outright recession. However, numerous economic indicators, including the Fed’s Senior Loan Officer’s survey, suggest to us that the economic recovery is intact and likely to continue. That should support further gains in U.S. stocks over the next 18 months, though likely at a more tepid pace than witnessed in the months following the market’s trough on March 23, 2020 (the S&P 500 up 85.5% since).

We are not at all surprised to see renewed concerns about inflation challenging technology stock valuations as investors vividly remember the NASDAQ’s mid-February correction as long-duration yields spiked. Though we do find it a bit surprising that real yields have actually declined of late and technology stocks have not responded in kind (see figure 3). It seems as if investors may still be hesitant to try the bowl of porridge out of fear that it might still be too hot. We suspect that a brief cooling off period (a 5% to 10% correction) might be needed before investors can once again find their appetite. As a reminder, Citi Global Wealth’s Global Investment Committee maintains a neutral weighting on U.S. large-cap stocks and is overweight on U.S. Treasury-Inflation-Protected Securities (or TIPS).

Figure 3. NASDAQ 100 Performance Relative to S&P 500 vs. Real 10-Year Yield
Figure 3: NASDAQ 100 Performance Relative to S&P 500 vs. Real 10-Year Yield
This line chart shows NASDAQ 100 Performance relative to S&P 500 (Left) and 10-Year Real Treasury Yield (inverted, %, Right) and indicates that real yields have actually declined of late and technology stocks have not responded in kind.
Sources: Bloomberg and Citi U.S. Wealth Management as of May 12, 2021. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance does not guarantee future results.