Our macroeconomic outlook is by now well-rehearsed: high interest rates tame inflation only by bearing down on economic activity. As the economy slows, corporate profitability declines, workers are laid off and unemployment rises. Given monetary policy operates with ‘long and variable lags’ in both directions, cuts to interest rates at this stage are invariably too little, too late, and the economy slides into recession. With unemployment already rising – both in the UK and the US – and GDP data pointing to a decline in US corporate profits in the first quarter of this year, we continue to see signs that the cycle is – albeit slowly – evolving as expected.
With yields on high quality short-dated bonds comfortably in excess of inflation, we see little to be gained in pinning our hopes on a positive economic surprise arriving just in time to validate very expensive equity markets. In this, however, we find ourselves in the minority. While many of the fund managers and investment strategists we speak with recognise the economy is slowing, belief in the Federal Reserve’s ability to manage an economic soft landing remains, for the most part, resolute. More worrying still, many market participants seem to think the stock market will prove immune to an economic slowdown. In our view, this belief is misguided, failing to recognise the range and interconnectedness of the risks stacked against it. We highlight four of the key risks below.
Economic cycles
The primary risk that investors are underestimating is a downturn in the economic cycle. Though high savings levels, fixed term mortgages and sound balance sheets have dampened the impact of rising interest rates, we have no doubt that, both in the UK and the US, an ever-increasing number of households and businesses are feeling the strain. The implications are becoming clear in the US labour market. The unemployment rate has risen from a low of 3.4% in April 2023 to 4.1% in June. If it rises only a little from here, the increase in joblessness will be sufficient to trigger the so-called ‘Sahm Rule’. Not a rule as such, this is rather an observation that, historically, whenever the unemployment rate has risen by half a percentage point within a year, it has marked the start of a recession, following which further job losses have been inevitable (Fig.1).
Of course, the Federal Reserve is well aware of this history, and stands ready to cut interest rates if necessary – and if permitted by further easing of inflationary pressures. Though the worst of the post-pandemic surge in prices is behind us, the Fed’s preferred inflation measure is making only slow progress towards its 2% target. Consequently, the Fed has signalled only one quarter-point cut in interest rates over the remainder of the year, despite the troubling signs in the labour market. In our view, a single rate cut will do next to nothing to support the real economy. Yet for the Fed to do more, the slowdown must be so pronounced that corporate profitability would surely be under marked pressure.
Irrational Exuberance and Stock Market Valuations
Counter to all economic rationale, it appears possible that rate cuts may, initially at least, stimulate further speculative gains in the stock market. We recently read a report from a US investment manager acknowledging the mounting risks to their base case of resilient economic growth. What struck us was the claim that the deteriorating growth outlook was encouraging them to increase their year-end targets for the US stock market.
From a purely mathematical perspective, falling interest rates can, in isolation, justify higher equity valuations. But rates will not fall in isolation: they will only head meaningfully lower in the context of a sharply slowing economy, and therefore sharply slowing corporate earnings growth. Interestingly, parts of the market appear to have taken this onboard: defensive sectors such as utilities and consumer staples have outperformed more economically sensitive sectors such as industrials and consumer discretionary. Yet, with the US stock market hitting a series of record highs in recent weeks, slower corporate profit growth is clearly not a widely held concern, giving rise to our second risk – that stock market valuations are unsupportable.
This brings us to artificial intelligence and the belief that some companies can grow their earnings irrespective of the economic cycle. With consistently strong profit growth in perpetuity, it is argued, there is almost no valuation too high for such companies. We are sceptical of such claims. Firstly, we stand firm in our belief that valuation is the difference between a good company and a good investment: even the very best company will prove a poor investment if it is bought at too high a price. Secondly, we have yet to find a company whose earnings are not, to some extent, influenced by the economic cycle – for example, Microsoft’s earnings per share dropped 13% in 2009 and Apple’s earnings fell 11% in 2016, even as the economy avoided recession.
At this point, we think it instructive to consider the history of Cisco, the US technology giant in the early part of this century. The company was identified as the leading provider of the ‘picks and shovels’ supporting the revolutionary potential of the internet. In five years, its share price rose 3,860% to a high of $80 in March 2000. In early July this year, Cisco’s share price was around $47, still 42% below its peak nearly a quarter of a century later. Importantly, this has occurred in spite of the company having grown its earnings by an average 14% a year over this period, meeting – or even exceeding – the expectations that were held to justify the eye-wateringly high share price all those years ago (Fig.2). Investors in Nvidia and the like would, we suggest, do well to reacquaint themselves with this history.
Financialisation
Such were the excesses of the tech bubble that its demise triggered a full-blown recession in the US. In response, the Federal Reserve slashed interest rates from 6½% to 1¾% in a little over a year. Regardless, unemployment rose from 3.9% at the end of 2000 to 5.9% by early 2002, and then – in spite of yet more rate cuts – to 6.3% by mid-2003. Cisco shares lost 90% of their value as, peak to trough, the US equity market halved.
Today, we hear all too often that a recession is impossible because household and corporate balance sheets are in good order, and there are ‘no clear imbalances’ in the economy.
This argument is used to justify relentless gains in the stock market, failing to recognise our third risk in the system: that the gains themselves are creating an economic Achilles’ heel. As a proportion of US GDP, wages have seldom been lower, while the size of the stock market has never been greater. Gallup calculates that 58% of American households have some exposure to equities, five percentage points higher than the previous peaks of ownership hit – ominously – in 2001 and 2007. The US economy has never been more exposed to the vagaries of the stock market. Mixed with stretched valuations and a deteriorating economic outlook, this strikes us as a heady and dangerous brew.
Politics: debt and elections
Our final risk in the system is easy to see but difficult to quantify. Here in the UK, with the scars from Liz Truss’ “mini budget” still raw, the challenges facing the new Labour government are self evident. Public services are in need of funding while growth could certainly benefit from a shot in the arm. Yet the tax burden is high and government debt as a proportion of GDP has never been higher in peace time. It seems likely that budgetary concerns must limit the Starmer government’s ambitions.
The US is flirting with a similar predicament. After huge unfunded expenditures through the pandemic, US government debt levels are also at record highs. The US government now pays more than $1trillion a year in interest, a fifth of its total revenues and a greater expense than its sizeable defence budget. Nonetheless, with November’s presidential election looming, neither candidate is keen to discuss the merits of – or need for – fiscal responsibility. The bond market, however, may not be so willing to ignore the issue. Though US sovereign debt remains the world’s ultimate safe haven asset, the government’s ability to issue ever greater quantities of it is not without bounds. Indeed, there are tentative signs that the infamous ‘bond vigilantes’ are beginning to probe the sustainability of the government deficit. At the very least, investors should question the extent to which fiscal policy can feasibly be relied upon to extend the current cycle, or to offset a future recession.
Risk Assessment
We have been surprised by the longevity of this economic cycle. The slow transmission of monetary policy, together with unparalleled fiscal expenditures, has allowed growth to endure far longer than we thought possible in a world of record debt and high interest rates. However, in doing so, we believe risk has been stacked upon risk. Investors’ refusal to countenance the likelihood of an economic slowdown and the consequences for corporate profitability – and to recognise that meaningful cuts to interest rates are only possible should growth weaken significantly – have propelled the stock market to precarious heights. Fearful of missing out, and emboldened by the mania surrounding artificial intelligence, more and more investors have eagerly climbed aboard, leaving the US economy more exposed to the risk of a correction than ever before. Meanwhile, there are signs that even the US government might be constrained in its ability to support future economic growth.
These risks are interlinked: we believe any one of them has the potential to topple the whole edifice. For these reasons, we remain cautious.
