When we last wrote, in May, we suggested markets were travelling much too hopefully, ignoring the likely consequences of an historically aggressive series of interest rate hikes. Since then, the US stock market has continued its upward surge, driven not by stronger company earnings, but by investors’ willingness to pay a higher price for those earnings. Having risen 27% from its October lows, the S&P 500 is trading at a multiple of more than 20x this year’s earnings, well ahead of the ten-year average multiple of 17x. These extraordinary gains have been fuelled by optimism that, having raised interest rates forcefully in the face of high inflation, the US Federal Reserve may now be on course to engineer a much hoped for ‘soft landing’.
In the soft landing scenario, fading inflation allows the Fed to start cutting interest rates before they inflict significant damage on the economy; growth slows and perhaps some jobs are lost, but crucially recession is avoided. The implications for investors are lower bond yields – and hence positive capital returns from fixed income allocations – and equity markets that are underpinned by solid, if unspectacular, earnings growth.
The appeal of the soft landing scenario is clear. But is it credible?
After a torrid 2021 and 2022, the year to date has been much more encouraging on the inflation front. The rate of growth in US consumer prices peaked at 8.9% year-on-year in June last year, but has since drifted down to 3.1%. Admittedly, core inflation (which strips food and fuel from the calculations, two areas where prices can be volatile and driven by factors beyond the central bank’s control) has proved more stubborn, but the trend has nonetheless been downward. Furthermore, signs of normalisation in housing rents and used car prices – major contributors to the inflationary surge – suggest there is good news still to come. At the same time, unemployment remains near record lows. Wages have been rising (in nominal terms, at least) at the same time that inflation has been easing. Surely this augurs well for a soft economic landing?
Unfortunately – and perhaps predictably – we are sceptical. While we acknowledge a soft landing is possible, we think it improbable. As many, including us, have repeatedly pointed out, monetary policy works with long and variable lags: the current state of the economy says more about interest rates as they were twelve or eighteen months ago than it does about the appropriateness of today’s policy stance.
Twelve months ago, US interest rates were 2.50%. Eighteen months ago they were just 0.25%. Today they stand at 5.50% with a further quarter-point hike possible before the Fed calls it a day. The Fed’s task is far from easy. Historically, soft landings are vanishingly rare. Given the violence of the post-pandemic economic cycle, the ferocious pace of the policy tightening and the Fed’s “data dependent” (i.e. backward looking) approach under Jerome Powell, the chances of success – either by luck or by judgement – appear slight.
We admit that we have been surprised by the resilience of the economy in the face of one of the most aggressive hiking cycles on record. In retrospect, we underestimated the endurance of the fiscal largesse enacted during the pandemic, the degree to which long-term mortgage deals would shield homeowners from the effects of rising interest rates and the extent to which inflation would support company earnings even as sales volumes deteriorated. However, we believe the inevitable has merely been delayed.
By most estimates, the stimulus cheques handed out by the US government during the pandemic enabled households to add around $1.5tr to their accumulated savings, equal to about 6% of annual economic output. These excess savings subsequently allowed many – though by no means all – households to weather the onslaught of inflation, ensuring consumption has remained a powerful engine of economic growth. However, data suggest this war chest is now close to empty, and signs of financial frailty among portions of the population are emerging. For instance, delinquencies on car and credit card loans are edging up, particularly among younger borrowers.
Unsurprisingly, banks are taking notice of the strain imposed by higher interest rates. A striking feature of this quarter’s earnings updates has been the news that US banks are already being forced to take higher write-downs on bad loans, and to set aside higher sums to cover future impairments. To try to limit the damage, they are tightening lending standards: more than one in five loan applications were denied in June, the highest rate of rejection in five years.
Meanwhile, the corporate sector is also coming under pressure. Though credit spreads (a measure of the additional yield demanded by bond investors to lend to riskier borrowers) have remained curiously subdued, the interest that companies must pay on debt has nonetheless risen sharply thanks to the Fed’s rate hikes. Consequently, companies are drawing in their horns: issuance of new high yield bonds over the first six months of the year is the lowest it has been since 2009. As debt is fuel for spending and thereby growth, its withdrawal is likely to weigh on the economic outlook.
More pointedly, increasing numbers of businesses are simply not able to bear the burden of higher interest rates. Bloomberg calculates that, globally, some $590bn of debt is either in default or distress and that bankruptcies are happening at a pace that, outside the early days of the pandemic, has not been seen since the depths of the financial crisis. We expect bankruptcy and default rates to climb steadily as, one-by-one, debts become due.
It is not particularly original to quote Hemingway at this point:
“How did you go bankrupt?”
“Two ways. Gradually and then suddenly.”
However, we think the lines that follow – and that are often left out – are also pertinent:
“What brought it on?”
“Friends. I had a lot of friends… Then I had a lot of creditors, too.”
As higher interest rates and tighter lending standards turn friends into creditors, we expect the resilience of the labour market to crumble. Unfortunately, job losses are inevitable as business models that, unwittingly or otherwise, were dependent on the availability of abundant and cheap financing are identified and exposed. Rising unemployment creates its own economic downdrafts, and so a recession begins.
The depth and severity of the recession depends in part on how long this process takes to play out. The longer interest rates remain high, the more dominoes are likely to fall – and the more spectacularly they are likely to do so. Seen in this light, ambivalent economic data which foster hopes of a soft landing seem much less benign.
We have for some time advised caution, reducing equity allocations on four occasions and skewing fixed income holdings towards high quality bonds which we expect to deliver meaningful positive returns in a recession. This is often the most challenging part of the cycle. In order to protect against the fall-out from the market’s excessive optimism, we have to be willing to position against it. Nonetheless our caution has at times been uncomfortable as equities and bond yields have marched higher. This discomfort is, we think, nonetheless worth enduring as we wait for the burden of high interest rates to finally make itself felt in the real economy – it is a price worth paying to make sure portfolios are well positioned when friends become creditors and the gradual becomes sudden.
