This article is from our April 2023 edition of MarketWatch.
24th April, 2023
The post-COVID-19 economy has been a confusing one for investors. First in the recovery boom of 2021, we wondered whether the surge in inflation would be transitory or not? Then, in 2022, when we realised it was not, we wondered whether central banks could engineer a soft landing from high growth / high inflation or would we crash land into a recession? The markets assumed the worst and crashed in advance, but the recession never came.
2023 began in high spirits with inflation on the decline and the economy holding up – the ideal ‘no landing’ scenario. However, as growth continued and inflation remained high markets realised that ‘no landing’ would eventually lead to a ‘hard landing’, as central banks would have to continue hiking interest rates to cool down the economy. Stocks and bonds turned and fell again.
To make matters worse, even though higher rates haven’t broken the economy, they have revealed fractures in the financial system. Three small American banks collapsed after depositors fled due to failures in risk management, and Credit Suisse was force-sold to its local rival for similar reasons. Amid flashbacks of 2008, central banks stepped in to shore up the system. Despite rising systemic fears, they did not turn from their fight against inflation, with the Federal Reserve (Fed), European Central Bank (ECB), and Bank of England (BoE) all raising rates in March.
Given the uncertainties of war, inflation and now the financial system, central banks are no longer providing forward guidance on their rate intentions. Instead, markets are again making their own minds up. This is most evident in the bond market, where interest rate expectations have flipped downwards again (see Figure 1). Are they right – should investors now brace for a crash landing?
Six months ago the strong consensus was that winter would bring recession for Europe and the UK and that the US would likely follow eventually. Interest rates had never been hiked so far so fast without a downturn, yet rates are higher now than expected last year, and still no recession.
Warmer than-expected weather and alternative sourcing meant that Europe didn't run out of energy, and despite blowing out their budgets during COVID-19, governments borrowed more again to soften the hit to households and businesses. As a result, the economy kept going. Even still it was close. The UK saw almost no growth in the fourth quarter of 2022 and the Eurozone was saved from contraction by Ireland’s out-sized multinational-fueled contribution.
Buoyed by COVID-19-era savings and higher wages, the US consumer continues to be the main engine of the global economy, although their spending growth is slowing. In the first quarter of this year, business surveys picked up across Europe and the US, more so in services than manufacturing. Higher rates have hit real estate though, especially in the commercial sector. However, China, the second engine of world growth, has thrown off its COVID-19 constraints to add impetus to the global rebound.
Economists refer to the decade after the GFC (global financial crisis) as the jobless recovery, as austerity and debt kept unemployment high and wage growth low. This helped to keep inflation and interest rates low, leading to a boom in corporate profits and above-average investment returns. Now, post COVID-19, we have the opposite macro conditions, and economists debate whether low unemployment and high inflation are the new normal for this decade.
Although wages are rarely linked directly to inflation anymore, large sectors of the workforce are reacting to higher inflation by demanding higher pay. The UK has been racked by strikes for months, and normally, sensible Germany, where unions and companies tend to cooperate, is seeing large-scale industrial action too. We expect more pay increases this year, which will keep service cost inflation high, and less next year as broader inflation fades.
However, there are longer-term demographic factors too. Aging and health issues are shrinking workforces. Political choices in the US and UK mean less immigration and fewer workers. In the US, Walmart raised its minimum wage by over 15% to attract workers, which will set a floor for other employers. Even in Japan, which has seen little wage growth for decades, companies are beginning to increase pay. Eventually, these trends will slow, but it is reasonable to expect lower unemployment and higher inflation in the 2020s than we had in the 2010s.
Given all the difficulties the global economy faces, the last thing we need is another financial crisis. Especially as the cure for such a crisis – turning on the money taps – would only worsen the inflation situation. However, we do not believe that recent bank failures are the start of another 2008 situation.
An important distinction is in the nature of the current banking problems. The GFC was a credit crisis, where banks had over-loaded their bloated balance sheets with mortgages and dubious derivatives, whose value evaporated. This time their balance sheets are smaller and they carry interest rate risk from more solid bond holdings. Stricter post-GFC rules, which were later relaxed for smaller US banks, mean that last year’s sell-off in bonds only dented bank capital rather than wiping it out.
Another important difference is the central bank’s response. In 2008 they were always on the back foot, desperately inventing rescue schemes on the fly, whereas this time, they had a playbook and they reacted decisively. Such swift action can raise doubts too, and concerns of overreaction, but for a system built on confidence, maintaining credibility is key.
It would be naïve though to assume that recent events will have no consequences. The smaller US banks are responsible for over half of all commercial and industrial lending in the country, even more so in property, and they were already tightening lending standards. Such credit contractions have historically been linked with recessions, although it’s not always clear which causes which. Fed Chair Powell noted that slower bank lending would slow growth and inflation.
Chair Powell also made it clear that rate cuts were not in the Fed’s plans this year, as fighting inflation remains their primary objective. While increasing the risk of recession, this means that bond yields’ recent decline may have been premature. However, weaker lending means that the peak in bond yields, and the risk of further loss from bonds, are lower than previously thought. We note that yields are still close to their highest level in over a decade, so bonds do warrant their place in a portfolio, especially in an eventual recession, where they should outperform cash.
Normally when the bond market expects a recession, longer-term yields dip below shorter-term yields, known as a yield curve inversion, and the credit spreads on lower-quality bonds increase. The yield curve has been inverted for some time, but yield spreads on lower-grade bonds are not far above average, meaning that credit investors are not being compensated for recession risk.
Similar to last year, the stock market has been driven by expectations for interest rates. The idea that central banks were close to their peak fueled the Q4 / Q1 rally until investors realised that the no-landing scenario meant higher rates. Now that banking fears have raised expectations of rate cuts, stocks have surged again, especially in the higher-growth sectors. Given that authorities have better ways to address banking issues, this feels over-enthusiastic to us.
Does this near-term exuberance mean that equity investors are headed for a crash landing? Economic downturns almost always see bear markets (down 20% or more), where earnings and valuations typically decline by 10-25% each. Corporate profits have stalled, but not fallen yet, which we would expect when slower growth meets higher wages and costs of capital. Valuations though have already fallen by circa 20% from their 2021 peaks, so markets are less vulnerable.
In conclusion, if the economy does suffer a hard landing, investors should have less to fear as markets have mostly descended in advance. Stocks are not particularly cheap, and some turbulence would be normal, but much of the typical decline already happened last year, and more modest valuations mean higher return prospects from here. At higher yields now, high grade bonds can once again provide some cushion in a portfolio, and alternatives showed last year that they can smooth the return experience too. So while we can’t rule out a bumpy landing, let alone try to time it, we take comfort from knowing that well diversified portfolios are better able to see us through one now than they have been for some time.
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Warning: Forecasts are not a reliable indicator of future performance.