'Bad Goldilocks' emerges as market's worst enemy

Long road ahead for markets
Long road ahead for markets   

Remember "Goldilocks," that pristine economic condition where growth was strong but not so strong as to induce tighter Fed policy? Well, now meet her evil twin.

This is the new state of affairs in the U.S., where growth isn't strong enough to inspire much confidence but not weak enough to induce easing from the U.S. central bank.

It's an uncomfortable place for investors, evidenced by a move away from stocks despite a strong week for the markets.

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Global equity funds surrendered a net $12.2 billion in outflows last week, the highest level of redemptions in five months and the seventh consecutive week of net outflows, according to Bank of America Merrill Lynch, whose chief investment strategist Michael Hartnett used the "bad Goldilocks" term to frame the current situation.

Source: The British Library

The outflows came amid a market that is up nearly 6 percent from at least a near-term intraday low hit Feb. 11, as measured by the S&P 500. Despite the market gains, investors remain leery over economic conditions, indicating the recent rally could be just a short squeeze likely to unravel.

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Mixed signals are the economy's biggest problem: While consumers continue to spend and the jobs market looks solid, particularly in terms of weekly jobless claims, other aspects continue to underperform.

Manufacturing, exports and business investment numbers are weak, corporate profits are contracting, and estimates of recession chances are climbing. Revised numbers for fourth-quarter gross domestic product are likely to show growth of just 0.2 percent, less than the meager 0.7 percent initial estimate and perilously close to contraction, according to Credit Suisse economists.

"The U.S. economy has not been immune to the shocks emanating from global economic and financial market stress. Net export growth has slowed significantly, equipment spending is much softer, and businesses aren't building inventories as fast as they might have otherwise," Credit Suisse said in a note to clients. "However, ... the domestic weakness to date has been concentrated mainly in specific pockets of the economy — especially those related to the energy sector."

Wall Street's efforts to ring-fence oil haven't gone over well with investors. Worries are rising that the sector's problems could bleed into other parts of the economy.

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Under some circumstances, it would be natural for investors to wonder whether the Fed might come to the rescue with some policy accommodation. In this case, though, that seems unlikely for a number of reasons.

Cleveland Fed President Loretta Mester on Friday expressed a widespread sentiment among policymakers, namely that the current weakness is bound to pass and there's no reason to ease.

"At this point, I see the market volatility and sharp drop in oil prices as posing risks to the forecast, but I believe it is premature to conclude they necessitate a material change in my modal economic outlook," Mester, a policy hawk, said in a speech.

It's not that the Fed doesn't have the tools, it's more that deploying them at this point would look like a panic move from an institution that is trying to calm markets. (Some easing measures mentioned in recent days include negative rates on bank deposits at the Fed and additional rounds of quantitative easing or Operation Twist, a balance sheet-neutral round of Fed bond-buying.)

Indeed, it will be a thin line for the Fed to walk, with an economy that is showing some signs of inflationary pressures — Friday's consumer price index gain among them — along with deflationary signs in energy and a wage picture that is somewhere between.

Bad Goldilocks, then, looks to be the nemesis ahead both for investors and central bankers.