A number of years ago, long before Jerome “Jay” Powell became Chairman of the Federal Reserve, your editor proposed something called the Ugly Goldilocks scenario.
You likely know the children’s story of “Goldilocks and the Three Bears.” Goldilocks didn’t want the porridge that was too hot, or the porridge that was too cold. Instead she ate the porridge that was neither too hot, nor too cold, but “just right.”
Wall Street has long used the phrase “Goldilocks Economy” to describe an economic environment that was “just right” for stocks to keep advancing.
For Wall Street, a Goldilocks Economy means economic conditions are neither too hot — which would mean inflation and rising interest rates — nor too cold, which would mean recession and falling profits.
Our modified term, Ugly Goldilocks, is what you get when the economy stays weak and sick, and the central bank keeps it that way, and the “ugly” part is helpful to the stock market.
Medicine isn’t always good for a patient. Sometimes it even makes the patient sick. Think of a cancer patient weakened by chemotherapy, or a back-surgery patient who winds up addicted to painkillers.
After the 2008 financial crisis, the “medicine” from the Federal Reserve was like that. The medicine was meant to heal the real economy. But it wound up making the economy sick instead.
The stock market loved it, though, and stocks went up, as the economy stayed weak. Better yet, the ongoing sickness of the economy meant, drum roll please, even more medicine.
The extra medicine prolonged the economy’s sickness, which further prolonged the administration of medicine, which helped the stock market grind higher.
Here is the gist of how “Ugly Goldilocks” worked:
- Near-zero interest rates meant that blue chip companies and large corporations could borrow in large amounts, but small- and medium-sized enterprises could not. The only entities a bank wants to lend to at super-low interest rates are those already big and profitable.
- Super-low rates gave blue chip companies and large corporations plenty of incentive to crowd the borrowing window, scooping up loans to buy back shares or pay special dividends. This activity, again, meant that small- to medium-sized enterprises could not borrow.
- The presence of low rates, and the perception created by quantitative easing, also made it easier for “zombie” companies with favored government status to survive, and for low-profitability corporate projects to survive through a constant stream of cheap financing.
- Low rates also inspired a frenzy of financial engineering on Wall Street — sophisticated paper-shuffling maneuvers to take advantage of easy credit — which in turn distracted public companies from capex investment in real productive things like plant and equipment upgrades.
The above factors, and a few others, kept the U.S. economy weaker than it should have been.
Consider what would have happened, for example, if interest rates had been allowed to rise:
- Rising interest rates would have caused blue chip companies and large corporations to stop borrowing heavily, because they were mainly borrowing to fund share buybacks and dividend payouts, and other activities that only made sense with access to super-cheap financing.
- Rising rates would have forced the banks to consider lending to small- and medium-sized enterprises — the businesses with real growth opportunities, which could have borrowed at higher hurdle rates to fund those opportunities, if given the chance.
- Rising rates could have forced zombie companies to go out of business, and non-economic projects to be shuttered for lack of cheap financing, which would have made room for actual high-growth projects to proliferate and expand, fueling sustainable growth.
The shorter version of the above is to say artificially low interest rates are good for big, slow companies, and financial engineering, but bad for productivity and real economic growth.
Higher interest rates, on the other hand, act like a sorting mechanism: The higher hurdle rate for borrowing ensures that only worthy projects are funded in the first place, which creates better economic results.
And at the same time, higher interest rates mean zombie companies go away, allowing for growth-oriented business models and well-managed enterprises to expand and take new market share (a beneficial thing for economic growth).
But instead of all that, the central bank kept interest rates near zero, and the funding super-cheap, supposedly in the name of helping the U.S. economy.
What they did instead, though, was help blue chip corporations buy back shares by the truckload, while enacting a full employment mandate for financial engineers on Wall Street — even as the real economic recovery stayed weak.
And again, Ugly Goldilocks persisted for a long time not just because the Fed’s economic medicine was unhelpful, but because the medicine was actively harmful.
To the degree that central bank medicine made the recovery slow and sluggish and weak, it perpetuated the delivery of even more medicine, which was great for equities (via share buybacks) but not for real economic growth.
The Fed’s bad medicine also facilitated a huge build-up of corporate sector debt. This led to the situation we are in now, where public corporations in general are more overextended and debt-leveraged than ever before.
Now, in 2020, there is another twist to the story. Ugly Goldilocks is becoming Mutant Goldilocks.
Whereas Ugly Goldilocks meant Wall Street could reap gains from an economic recovery that was weak and sick — thanks to continued medicine from the Fed — Mutant Goldilocks is reaping gains from the Federal Reserve and the U.S. government simultaneously.
Then, too, in some ways, Mutant Goldilocks is far, far worse than Ugly Goldilocks. In this new arrangement, Wall Street benefits from seeing millions of businesses die.
Think what happens when small- and medium-sized enterprises close their doors forever en masse. The consumers who were served by those small- and medium-sized enterprises have to turn somewhere else instead.
And who will they be forced to turn to? The national chains.
Take New York City for example. According to a report from the Partnership for New York City, an influential business group, a full third of New York City’s 240,000 small businesses will never reopen. “So far, those businesses have shed 520,000 jobs,” the New York Times reports.
Small businesses “represent 98% of employers in the city and provide jobs to more than 3 million people,” the New York Times goes on to add, which amounts to 50% of New York City jobs.
The numbers for New York are in the same vicinity as the national average.
Small businesses are responsible for 49.2% of private sector employment, according to the U.S. Small Business Administration (SBA). They represent 99.7% of U.S. employer firms and 64% of net new private-sector job creation.
By Mutant Goldilocks logic, it is totally fine for one-third to one-half of these businesses to shut their doors forever. Mass unemployment and misery? If met with a stimulus flood, no problem!
After all, large public companies, strong enough to survive an economic semi-extinction event, should be able to step in and harvest a bounty of stranded consumer demand when all is said and done.
One man’s bankruptcy is another man’s extra penny of earnings per share. The pain of the weak accrues to the bottom line of the strong, with cookie-cutter brand homogenization as far as the eye can see.
Imagine all the local restaurants in your neighborhood shutting their doors forever, with only Applebees, Burger King, and Outback Steakhouse remaining.
Then imagine lines out the door at all times, and all three raising prices, simply because they can. Relative to stranded demand, where else are consumers going to go?
Mutant Goldilocks is not a pretty picture. The picture grows worse when one considers the net impacts of tens of millions of Americans permanently out of work, either scraping by or trying to make ends meet with new rounds of government stimulus.
In the dystopian environment described here, large amounts of currency supply (via the twin turbines of monetary policy and fiscal policy) keep blowing into the system, causing inflation by way of too much currency chasing too few goods against a persistent backdrop of supply-chain bottlenecks.
Shortages and supply-chain disruptions could become a regular feature of this ugly landscape, but surviving public companies could come out smiling — because they could experience greater pricing power as a result of a persistent supply-demand mismatch (via countless small businesses gone).
Then, too, valuation multiples can keep expanding, even as the stock market loses ground in real terms, if spot instances of price inflation are rising even more than nominal equity returns.
Picture an inflationary recession — or inflationary depression, if things get ugly enough — with the Dow rising 10-15% a year as the real cost of living rises 15-20%.
Can one still argue, then, that the stock market is placing its chips on a V-shaped recovery? Or hope for a fast vaccine roll-out? Or an assumption that things will “get back to normal” soon, even as COVID-19 data trends largely indicate worsening outbreaks and strained hospital systems all across the country?
We would argue no, not at all. The market is not wearing rose-colored glasses here.
If the Mutant Goldilocks theory is on point, a rising market can keep on rising — no matter how awful the real-economy destruction, and no matter how ugly the pandemic gets — because the underlying drivers behind such a rise may not be geared to recovery, but rather to one of the most dystopian and grim “real-economy aftermath” scenarios one can imagine.
This would also explain why the market doesn’t seem to care — not a little, not at all — about the dire state of the “fiscal cliff” vis-a-vis stimulus negotiations in Congress, and the threat of millions of Americans finding themselves jobless, or even homeless, within weeks, if not days.
Omni Consumer Products, the all-encompassing sociopathic mega-corporation from the 1987 movie RoboCop, comes to mind here. One can be assured that, if some real-world approximation of the RoboCop world comes to pass, Omni Consumer Products’ shares would be a buy.