Despite the old adage ‘don’t fight the Fed’, that’s exactly what is currently happening with the market pricing in at least 50bps of cuts in interest rates by the end of 2023. Although the Fed expects rates to stay higher for longer.
This anticipated pivot by the market is clearly at odds with the Fed’s anticipated ‘pause’ and will likely lead to increased volatility in fixed income markets as investors try to weigh up the prospects ahead.
Evaluation of where we are in the economic cycle points towards being at the early phase of economic contraction as macro data softens from the post-covid re-opening highs. After over 12 months of aggressive monetary tightening by most central banks, it’s unsurprising it’s beginning to take a toll on economic growth. However, with inflation proving stubborn, especially core services inflation, central banks are unlikely to ease up in their efforts to suppress it.
What might change this is evidence of broadening and persistent disinflation across agriculture, manufacturing, construction and services. This seems like quite a tall ask, but not out of the question.
Why? For three reasons:
- Financial conditions have already significantly tightened following the 4.75% increase in US rates since the beginning of 2022;
- The labour market is beginning to show signs of increased weakness; and
- On-going quantitative tightening as central banks reduce their balance sheets and withdraw excess liquidity in the system.
Tightening financial conditions
With markedly higher interest rates, both supply and demand for credit has meaningfully slowed, with both the Senior Loan Officer Survey in the US and Credit Conditions Survey in the UK pointing towards credit contraction, providing a clear steer of more challenging times ahead as demand softens.
Source: Federal Reserve
Central banks raising rates further will merely serve to tighten credit conditions and exacerbate the risk of a deeper and longer recession – something markets are currently not discounting.
Labour market looks increasingly fragile
As the cost of debt rises and economic growth slows, businesses are increasingly focussed on cash preservation and balance sheet stability. This is seen most clearly amongst small businesses where access to finance has arguably been tightened the most.
Given small businesses make up 44% of private sector employment, account for nearly 79% of all job openings, and more than 90% of the post-pandemic increase in labour demand, this is a key area to watch to gauge the outlook ahead. And what is abundantly clear is that small business sentiment is deteriorating, and with it their plans to hire staff and invest.
Source: National Federation of Independent Business (NFIB)
This points towards the prospect of rising unemployment and a resulting squeeze on consumption that may act as a further drag on GDP growth.
Quantitative tightening
The Fed is cutting back its bond portfolio by about $95bn per month by not purchasing new securities to replace maturing bonds. And despite the regional bank liquidity challenges that resulted in the collapse of Silicon Valley Bank and Signature Bank, this isn’t expected to change as the Fed remains resolute in its determination to reduce its balance sheet - and it has a long way to go to get back to pre-covid levels. As a result, we can expect a continued contraction in liquidity, acting as a headwind to economic activity and GDP growth.
US Federal Reserve Total Assets
Source: fred.stlouisfed.org
Debt ceiling
Fiscal policy also serves as a source of uncertainty for investors. After the largess of the covid years, balancing the books is gaining increasing focus, especially as the cost of debt has taken off. US federal government interest payments have risen over 40% YoY to over $200bn as a result of lofty levels of debt combined with higher interest rates.
Source: Bureau of Economic Analysis
This is feeding into the increasingly fractious negotiations around the US debt ceiling (the total amount of money the US government is authorised to borrow to meet its existing obligations), which is now at the upper limit of $31.4 trillion.
With neither Democrats nor Republicans willing to concede ground it’s likely this will be a protracted process that may well lead to partial government shut down and even risk a credit rating downgrade which could spook the markets and cause more unwanted volatility and uncertainty.
What does all this mean for investors?
The economic growth outlook appears to be subdued and below trend. Despite the recent better than expected economic resilience in the US and EU, the delayed effect of higher interest rates is starting to take its toll on governments, corporates and households alike. And the combination of moderating sales growth with increasing margin pressures is likely to weigh on corporate earnings, representing a challenge for equities.
However, there’s select opportunities within growth assets for long term investors, like Emerging Markets, where valuations are attractive and scope for upside surprise to conservative earnings expectations exist.
As disinflation looks set to continue, the outlook for defensive assets such as government bonds and investment grade credit, looks more compelling. With yields now typically 3.5-4% in government bonds and 5-7% in corporate bonds, and long term inflation expectations remaining controlled at <3%, the prospect of earning positive real returns in addition to potential capital appreciation is enticing. And with this comes the prospect of uncorrelated returns between fixed interest and equities re-establishing itself, which multi asset investors will warmly welcome.
There remain many challenges ahead for investors, but as advocates of long term investing and maintaining a disciplined and diversified approach with strong governance and oversight, from these challenges come opportunities. With an investment process designed to deliver through the economic cycle by favouring quality as a style and with cashflow, profitability and balance sheet strength common hallmarks of our approach to investing, we expect to support your clients by coming through this period of uncertainty relatively well, setting us up nicely for the recovery, as and when it comes.
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