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In a muddled world of current cyclical pressures mixed with longer-term geopolitical, demographic and clean energy transition shifts, there is a building uncertainty about the direction of global economies. This is certainly creating a highly complex environment where a multitude of outcomes are still possible. Huge political figures with their own agendas are escalating tensions on a weekly basis, demographic shifts and nationalism (e.g Brexit) are increasing labour scarcity and the energy transition is creating winners, losers and a more expensive market for carbon.
At the same time, the post-Covid economy is having to reckon with the shorter-term cyclical pressures. Aggressive fiscal and monetary stimulus as the pandemic took hold came at a time of a chronic breakdown in global supply chains, mismatching supply and demand like never before. Inflation responded by racing higher and signalling to markets that supply needed to keep pace. Over the past year, supply shortages have started to ease, yet labour markets have remained tight as the US economy continues to create jobs far in excess of the growth of new workers. As a result, service sector inflation remains resilient.
To navigate this landscape, it is best to disentangle and understand the cyclical pressure points.
For over a year, the US Federal Reserve (Fed) has been raising rates in an aggressive bid to reduce demand and allow supply to catch up. As the Fed tightened, other global central banks were also focussed on the fight against inflation. The result has been a synchronised tightening in financial conditions.
Notwithstanding a concerted tightening in monetary policy, global growth has remained surprisingly resilient. In particular, the US economy has shown relatively low sensitivity to increases in short-term interest rates. Strong household balance sheets, long maturity of US mortgage debt (typically 15 to 30 years) and the increase in corporate debt as businesses took advantage of the era of ultra-low rates, have kept demand resilient even as rates moved higher.
Low sensitivity to interest rates was always going to be the Fed’s Achilles heel because its key policy tool is less effective at restraining demand in a timely manner. It also increases the possibility that monetary policy lags have lengthened, increasing the uncertainty over the level at which interest rates become restrictive. The Fed do not think they are at the right level yet.
With every step up in interest rates, the risk that something within the financial system breaks has only grown more plausible. A decade of ultra-low interest rates was also likely to have led to investor complacency and the mispricing of long-term risk. This has now started to come to fruition.
During the course of last year there was gathering evidence that risks were building up within the financial system. The implosion of the crypto industry following the collapse of a leading exchange, FTX, was the first casualty. Liz Truss’s ill-fated budget was another. Last month’s collapse of Silicon Valley Bank, Signature Bank and Credit Suisse are the most obvious casualties of the central bankers’ quest for price stability.
In the US, regulators not only guaranteed all deposits (including uninsured) of the banks in receivership, but they also launched a new temporary lending programme that allows banks to borrow from the Federal Reserve using the par value of treasury bonds as collateral. Given the large unrealised losses across the banking system associated with treasury bond holdings, such a programme has proved successful in arresting the near-term financial stress.
Even so, financial conditions are likely to continue tightening and could still tip the economy into a recession for two main reasons. First, as inflation continues to head lower, real interest rates will mechanically move higher as inflation is expected to fall a lot faster than interest rates. By the second half of the year, real interest rates in the US are likely to be between 1-2% – a level that typically leads to a significant slowdown in demand.
Second, banks are likely to pull back from lending in response to higher funding costs (as deposits continue migrating to money market mutual funds in search of higher returns) and more prudent balance sheet management (in response to rising delinquencies and defaults). This is likely to be particularly true for regional banks, which play an outsized role in providing roughly 40% of all loans to the US economy and approximately 70% of loans to the commercial real estate market.
Central banks have therefore arrested a fast-moving outflow in deposits for the majority of these regional banks, but are unlikely to do much to avert the slow-moving credit tightening that is now underway.
As we look to the end of 2023, there continues to be a wide range of positive and negative potential outcomes. On the downside, credit availability is falling and inflation could also remain resilient – mark-ups continue to surprise on the upside as global businesses seem to be successfully pursuing price over volume strategies. On the upside, a pause and then a cut in US interest rates could lead to a huge sigh of relief across the world and breathe fresh life into financial markets. Whilst we do not expect a rate cut from the Fed next Wednesday, we are interested to hear what Chairman Powell has to say. In the meantime, we are building exposure to less volatile areas of the equity market and investing in stocks with strong revenues and high levels of positive cashflow that we expect to benefit if credit conditions should deteriorate further in the short term.
This is a summary of what our investment team have been working on, and away from this we do all hope that you are keeping well. Have a lovely weekend.
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