Earlier this month, the US Federal Reserve delivered a long-awaited cut to its policy interest rate. Significantly, rather than stick to its typical quarter-point increments, the Fed felt able – or, more ominously, compelled – to reduce rates by half of one percent. The distinction is important. The benign interpretation is that the larger reduction was permitted by the slowing pace of inflation. At 2.2%, the Fed’s preferred inflation gauge has fallen a long way from its 2022 peak of 7.2% and is within touching distance of the 2.0% target. More worryingly, the move was made against the backdrop of slowing job creation, rising unemployment and faltering consumer confidence: might the outsized cut have been made in an attempt to forestall economic troubles ahead?
The market’s verdict is clear: the consensus is firmly behind the benign view – a soft landing for the economy, with inflation and interest rates falling without a meaningful rise in unemployment or slowdown in growth. In our view, adherents to this belief may well be confusing the current situation with the direction of travel. The US economy has proved remarkably resilient as interest rates were raised to, and then maintained at, multi-decade highs. We think investors should be asking ‘what next?’ We see evidence that the economy is weakening, and suspect the Fed has little power to arrest the decline.
How have financial markets responded to the rate cut?
Equity markets have, since late 2023, been fuelled by a growing consensus around a soft-landing narrative that demands interest rates fall rapidly while the economy and corporate profits remain resilient. From this perspective, it was perhaps inevitable that the jumbo rate cut was initially met with enthusiasm: US stock market indices climbed to all-time highs, while those tracking economically sensitive smaller companies were particularly buoyant. Interestingly, the initial gains were quickly rescinded, and subsequent advances have been more tentative.
History certainly suggests equity investors should be cautious when the Federal Reserve begins to cut interest rates. The reason is simple: as highlighted below (fig.1), reductions in interest rates are typically associated with recessions, and recessions are bad for corporate profits and therefore equity markets.
Equity investors, though, have tremendous reserves of optimism. Despite the tendency for falling interest rates to be accompanied by recession, the first rate cut in a cycle has all too often elicited a positive market response. For example, exactly 17 years to the day before this month’s move, the Federal Reserve also cut rates by ½%. Back then, the decision prompted the biggest one-day gain in four years with a certain investment bank, Lehman Brothers, rising nearly 10%. Needless to say, this enthusiasm proved hopelessly misplaced. The US stock market peaked just three weeks later while the economy had tipped into recession by January 2008. Importantly, some investors saw the writing on the wall, trusting to foresight and reducing equity allocations in advance of a stock market decline which measured 56% from peak to trough.
Despite engaging in an exercise that is inherently forward-looking, the investment industry has a remarkable propensity to find comfort in the status quo, and a will to believe in narratives – however fanciful – that might help it endure. We think this tendency explains how investors can, in aggregate, get it as demonstrably wrong as they did in 2007 and why we suspect they are making a similar mistake today.
Skate to where the puck is going
“Skate to where the puck is going, not where it has been.” So said the all-time leading goal scorer in ice hockey’s NHL, Wayne Gretzky. We consider this sound advice, particularly in the current economic environment. Yet we suspect that the vast majority of economists, investment strategists and investors who believe in the likelihood of a soft economic landing have their eyes firmly fixed on where the puck has been.
The US economy has proved remarkably resilient in the face of higher interest rates. Thirty months after the Fed first raised interest rates, its Chicago branch estimates GDP is growing at an annualised rate of 2.9% while the unemployment rate is just 4.2%. This, it is claimed, is far from a recessionary environment. We would counter that investors should focus not on where the economy is, but rather on where it is going.
Almost by definition, a recession involves a substantial increase in the unemployment rate. It stands to reason that a low current rate of unemployment does not prevent an increase from happening – if anything, it makes it more likely. Recent data have pointed to an unambiguous slowdown in the labour market and, though still low by historic standards, the unemployment rate has risen significantly from its post-pandemic lows. Indeed, this increase has been sufficient to trigger the so-called ‘Sahm rule’ which observes that a rise in the unemployment rate of this scale has historically – without fail – coincided with a recession (fig.2).
Meanwhile, business surveys point to a manufacturing sector in decline with little sign of recovery in sight and a service sector that, though currently strong, is increasingly worried about future demand and scaling back its hiring and investment plans accordingly. We note the proportion of household income being saved has fallen to historic lows, while delinquencies on consumer loans are rising. According to the Conference Board, individuals are increasingly worried about their job prospects and future economic conditions, posing a threat to consumer spending that has, alongside government expenditures, propelled the US economy through the many trials and tribulations of the past few years. Finally, the small companies that produce c45% of US economic output and employ c50% of the labour force continue to struggle under the burden of interest rates which – even after the Fed’s cut – remain penal, reporting sharp declines in earnings and concerns over future sales prospects.
Where some see a US economy that has to date proved remarkably resilient, we see one that is finally succumbing to the normalisation of post-pandemic distortions and the pressure of high interest rates. That it has taken so long for the Federal Reserve’s actions to bear down on the economy is instructive. Supported by historic precedence, it leads us to be extremely doubtful of the idea that reducing interest rates now will be sufficient to curtail or reverse the economic slowdown which is now underway.
If not the Fed?
If it is too late for lower interest rates to stave off a downturn, is there anything else on which equity investors might pin their hopes? We can identify two possible contenders, but neither is without its problems.
Firstly, growth could be supported by further government spending. At first necessitated by the shock of the pandemic and subsequently extended to pursue various political and strategic agendas, government expenditures have been a ferocious tailwind for US economic growth in recent years. With an election looming, neither Democrats nor Republicans are keen to discuss fiscal restraint. Whoever is elected, it is possible that a further wave of government stimulus could be forthcoming. While any such policy may support economic growth and asset prices, it would also likely be inflationary, necessitating higher interest rates. Additionally, with the budget deficit already at an historic peacetime high, it is distinctly possible that investors would demand a higher yield from US Treasuries, making it more challenging to service the deficit and tightening global financial conditions.
Alternatively, perhaps the wealth created by the phenomenal increase in asset prices in recent years could prove sufficient to cushion consumers from a standard cyclical economic downturn? The Federal Reserve estimates total US net household wealth stands at a staggering $163.8 trillion, a c40% increase from pre-pandemic levels. In theory, households could draw down this wealth to fund consumption, limiting the scope of any potential economic contraction. In practice, there is an inherent reflexivity to asset prices that we think undermines this scenario. Firstly, if these assets are sold en masse, the laws of supply and demand suggest their price should fall; households would find themselves less wealthy than they had presumed and potentially scale back their consumption, exacerbating the cyclical downturn rather than offsetting it. Perhaps consumption could instead be funded by further asset price gains? All else equal, higher asset prices mean lower future returns: at some point, the virtual spiral must grind to a halt. With US equity valuations at levels rarely ever surpassed, we suspect this point is close
Conclusion
When posed the question ‘what next?’, our honest assessment is that challenging times lie ahead. We are willing to stand out from the crowd when our analysis leads us to question the consensus – this is one of those times. We do not dispute the fact that US economic growth and stock market returns have been remarkably strong in recent years, even as interest rates have been raised to multi-decade highs. However, we think it is a mistake to confuse the current situation with the direction of travel. We see clear signs that the economy is weakening, and believe that cutting interest rates will do little to arrest the decline in the near term. Though we look forward to the day we can provide you with a more optimistic investment update, for now we continue to advocate caution.
