One of the more striking – if underreported – developments last week, was stalwart dove Lael Brainard turning what, for her, counts as hawkish at an event in New York.
The similarities between her comments and those that emanated from Jerome Powell during his first testimony on Capitol Hill as Fed Chair were notable. Specifically, she parroted the “headwinds become tailwinds” line and she also seemed to confirm that Fed risk is now skewed definitively to the upside.
The problem – if that’s what you want to call it – with the whole “headwinds become tailwinds” narrative is pretty clearly that we’re already late cycle, so it’s not really clear that we need any more “tailwinds.” In fact, the fiscal “tailwind” that Trump created by piling expansionary fiscal policy atop an economy operating at full employment now threatens to pull forward the end of cycle.
But as Goldman writes in a new note out over the weekend, the risk of that may be overstated. To wit:
In the classic post-war recession model, overheating leads to rapid wage growth and sometimes commodity price spikes, inflation rises quickly, and the Fed tightens abruptly. But it has been a while since a recession of that type last occurred. Today, with inflation expectations well-anchored and energy prices moderated by shale, the risk of runaway inflation appears less threatening than a raw reading of history might suggest.
Instead, Goldman focuses on something Powell said last year – namely that downturns are now more likely to be catalyzed by the unwind of egregious financial excesses.
In order to get a read on that, Goldman draws on previous academic work as well as Treasury and Fed’s research to build a “financial risk monitor” that incorporates measures of valuation, risk appetite (in one category) and financial imbalances and vulnerabilities (in another). Here, in brief, is what’s included:
Valuations and Risk Appetite
- Housing
- Commercial real estate
- Consumer credit
- Business credit
- Equities
Financial Imbalances and Vulnerabilities
- Households/consumers
- Non-fin businesses
- Financial businesses
- Government
There are a lot of factors that are incorporated into each one of those components and sub-components, but let’s just skip to the results. Here’s Goldman:
Exhibit 3 shows how the risk assessments for the various asset classes and sectors have evolved over time. The heat map captures the moderate degree of financial excess (red) in 1999-2000, concentrated in the equity market and the nonfinancial business sector, as well as the strikingly broad-based financial excess from about 2004-2007, concentrated in the housing market and in the household and financial sectors. It also captures the long period of restraint (blue) during the recovery years. At this point, our tool indicates much less risk of overall financial excess than before either of the last two recessions.
If you zoom in on the current 3-month average of Goldman’s assessments for various sectors, measures, assets, etc., compare them to where things stood in the fourth quarter of 2006, and make a super-fun spider web, here’s what you get:
So that’s a mixed bag. Goldman calls this “mostly reassuring”, but clearly there are problem spots and they are precisely where you’d think they would be. Here’s Goldman again:
Business credit signals more risk, with spreads tight– especially on high-yield debt–and lending standards fairly easy. Finally, equity market risk looked quite elevated over the last few months on average despite somewhat mixed messages from valuation metrics, though the risk score fell in February as a result of the sell-off, strong earnings news, and the increase in the VIX.
Additionally, the government sector is obviously in bad shape and that’s set to get materially worse going forward. You already know why (see here).
The overall message is that from a kind of 30,000 foot perspective, things don’t look particularly concerning, unless of course you count the distinct possibility that the Phillips curve is not in fact dead (it’s just sleeping) and/or the notion that grossly overvalued stocks will eventually come back down to earth and/or the self-evident conclusion that credit spreads will have to widen out eventually lest we should all end up turning into the BoJ by buying negative-yielding corporate debt.
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