It has been one of the most widely forecast recessions in a generation. A traditional boom-bust economic cycle straight from the textbooks. Excess spending by both government and consumer in the aftermath of lockdown pushed aggregate demand higher, while global supply chains, disrupted by the pandemic, forced aggregate supply lower. Higher prices were a natural consequence. Low interest rates were no longer needed. Throw in adverse geopolitics and it was clear that global central banks needed to change course.
Rate hikes happened at breakneck speed, with one of the swiftest monetary policy tightening cycles seen in a generation. From the Federal Reserve (Fed) to the European Central Bank (ECB) to the Bank of England (BoE), we witnessed monthly hikes, sometimes half a percent rather than the typical quarter of a percent. This had the economic commentators hopping with insights – we were going too quickly, too slowly, too aggressively, too calmly. The majority reached the same conclusion – that the only thing we should expect to accompany this level of tightening should be a full-blown recession. ‘Run for the hills’ was the message.
That was the theory. Sixteen months on from March 2022 when the Fed first raised rates and today’s reality seems very different. The global economy has gone from strength to strength. Naturally there are pockets of weakness but hard data like consumer spending and corporate capital expenditure have been on an upward trajectory. Softer data like consumer sentiment can be more volatile, but on average the trend there too has been upwards. Admittedly there is some differentiation in the data. Smaller businesses are less optimistic given higher financing and labour costs; big business is not of the same mind. Large firms are passing on higher costs to consumers and profit margins have yet to be materially impacted. Equity markets have been calmed.
Why is the reality different and how long could we expect it to remain so? Most forecasters have framed higher mortgage costs as a burden on disposable spending, with homeowners and renters alike set to suffer. Yet spending has not slowed, despite the running down of excess savings accumulated during the pandemic. The reality is partially hidden in the mortgage market with higher costs impacting different geographies in different ways.
In the UK, roughly, 35% of the population have no mortgage at all, 30% have mortgages and the rest rent. Furthermore, 84% of those with mortgages are on fixed rates, up from 50% in 2016. According to the BoE, a good proportion have yet to re-mortgage onto higher rates. Forecasters are calling it the ‘mortgage cliff-edge’ but in reality, it is a ‘mortgage slope’, and demand for goods and services remains robust in this country.
In the US, consumers purchase thirty-year mortgages, rather than the two- or five-year mortgages in the UK and are therefore well shielded from the rate rises. One suggestion is that house prices in the US are strong because there is no supply, as consumers put off house transactions until mortgage costs fall. That shouldn’t impact their short-run ability to continue spending, which contributes around 70% of US GDP. The labour market in both countries is extremely strong. If consumers still have jobs and wage bargaining power, its easy to see where the momentum is.
So is it time to throw out the textbooks? Is theory of no use to us anymore? The textbooks do make allowances for the lagged effects of monetary policy. We know they work with a delay, but sixteen months seems long. The reality is that the economic theory of the past hasn’t been updated to understand what happens to an economy after a decade of quantitative easing and excessively low interest rates. If we have all grown accustomed to cheap financing, why wouldn’t we assume that’s a permanent feature of economic life?
More likely, we think that forecasters are anticipating another exogenous event shocking the financial system and bringing about an end to this robust period for economic growth. Of course forecasting a single event is foolhardy and no serious economic commentator would do such a thing. The reality is that there is some merit to the concept. Today we are seeing the supply of credit contract, evidenced by the Fed Senior Loan Survey and the credit availability surveys undertaken by the BoE. When short rates are higher than longer rates (a.k.a. yield curve inversion), it is less profitable to lend. Ultimately, this may have the final say.
We had the index-linked gilt fiasco with UK pension schemes back in September of last year, followed six months later by the ructions of Silicon Valley Bank in March. If we should expect another domino to fall, perhaps that could be within another six months? Forecasters care less to speculate about what this domino might be as this risks reputations. Commercial real estate in the US is often suggested, and more recently private credit. The more episodes we have, the more the supply of credit contracts as risk-averse behaviour from lenders takes hold.
If there is anything we can take away from the Great Financial Crisis of 2008, it is that an economy can shut down quickly when banks decide to stop lending. This negatively impacts consumer spending behaviour, as it did almost overnight back then. For now, our advice would be to be cynical of the theory but have your portfolios prepared for when the reality of high interest rates actually bites.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
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An edited version of this article was originally published in FT Adviser.