Beware the Fed

Markets have had a rocky start to the year, with expensive growth stocks bearing the brunt of selling. Key to this has been an aggressive repricing of rate hike expectations from the US Federal Reserve (Fed). Market expectations for rate hikes in the US are now as high as they have been at any point in the post Financial Crisis period. Markets are pricing around 5 rate hikes this year, two more than they were in November. Fed commentary has also been more aggressive.

Source: Refinitiv DataStream, Drummond Capital Partners

In line with this, the spread between two year and three month yields in the USA has risen the highest level since 2010 in an extremely short period of time. Conversely, the spread between ten year and two-year yields has narrowed significantly, suggesting markets are pricing lower growth and inflation in response to tighter central bank policy. In this Insight, we explore how far the Fed will go and the likely impact.

Why is the Fed Raising Rates?

The Fed (alongside most other central banks) aims to balance price stability and full employment. Put simply, this means they want to keep the economy as strong as possible without generating too much inflation. As these two goals are contradictory and any change they make to policy impacts the economy with a long lag, inevitably the job they face is at times very difficult. Now is such a time. Inflation in the US is well above the Fed’s target (see below), and while economic growth has been robust, it is likely to moderate in the quarters ahead. This has forced the Fed’s hand. Whether they will be able to engineer a smooth landing for the economy will depend in large part on the sensitivity of the economy to rate rises and how quickly supply chains normalise. Other central banks are not in as great a predicament. Most expect to tighten policy in the years ahead, but not to the same extent as the Fed.

That said, we expect inflation in the USA to moderate through this year. Our modelling suggests under a variety of supply chain related scenarios (which were a key driver of above target inflation through last year), core PCE inflation (the Fed’s preferred measure) should ease to around 3% by early next year. Unfortunately, 3% is still above the Fed’s target of 2%, implying that work needs to be done to cool the economy. The other takeaway is that with much of the supply chain inflationary pressure already built into the system, the difference in inflation outcomes between good and bad supply chain scenarios won’t be that large until later this year.

  

‍Source: Refinitiv DataStream, Drummond Capital Partners

‍The Impact of Higher Rates

The big question is whether the US economy is strong enough to face interest rates high enough to restrain inflation. Based on our Growth Barometer, the US economy has been slowing since December last year. The Atlanta Fed GDP Now estimate of Q1 growth is currently at 0.1%, essentially implying a very weak start to the year.

Source: Refinitiv DataStream, Drummond Capital Partners

‍Consumer confidence has fallen since the middle of last year and real disposable household income has fallen persistently in the last few months, with inflation eroding any wage gains. The weak start to 2022 hardly represents the ideal time to be increasing interest rates, particularly from a market perspective.

Economic growth in the USA is also likely to moderate in the year ahead regardless of what the Fed does. The impact of fiscal stimulus will fade, explicitly dragging on growth numbers. In addition, longer term interest rates have risen materially. The historical relationship between the US 10-year bond yield and the ISM Manufacturing Index suggests that the Index will trend towards around 50 by the end of the year, a reading which suggests manufacturing activity is no longer expanding.

Whether households can bear higher interest costs is another concern. Currently, debt servicing costs represent a near record low share of household disposable income when abstracting from one off stimulus payments. This reflects a combination of very low interest rates and the household deleveraging which took place following the Financial Crisis. Using household income and debt data, we can map out how sensitive households are to higher interest rates (see below). An increase in borrowing costs of 1 percentage point (1) will take the share of disposable income households need to contribute towards debt repayment back towards the post Financial Crisis average – hardly a significant burden. Even a three-percentage point increase (which is higher than anyone is suggesting) would see the aggregate repayment drag well under that seen during the 2000s.

Despite the apparent capacity of households to deal with higher interest rates, this does understate the impact somewhat. Every percent of household income that is directed towards interest repayments is taken away from household consumption or savings, a net drag on economic growth. There are also indirect effects from higher interest rates. Housing market activity will slow, as will purchases of other large durable goods which are normally financed, such as cars.

Source: Refinitiv DataStream, Drummond Capital Partners

We can also estimate the equity market earnings sensitivity to higher interest rates by diving into whole of market balance sheets and income statements.. Every one percentage point increase in the average interest cost would reduce market level EPS by around 3.5%.. Over time, a reduction in leverage across developed markets has reduced their sensitivity to higher borrowing costs.

There is clearly also a valuation impact from higher interest rates on equity markets. Our previous analysis suggests that every one percentage point increase in long term interest rates should reduce valuations by around 15 percent, all else equal. In addition, there will be a hit to the market’s top line given lower economic growth.

Overall, from a structural point of view, US households and corporates are in quite a strong position to wear higher interest costs. However, this doesn’t alleviate the pain along the way that both sectors will feel as rates increase. After all, that is the point of the Fed’s very blunt instrument. Their only way to reduce inflation is to reduce demand.

‍Can the Fed Achieve a Soft Landing?

In an ideal world, the Fed would raise interest rates just enough to bring inflation back to target without causing undue harm to the economy. Unfortunately, we don’t live in an ideal world and more often than not, they fail in that objective. The figure below shows the state of the manufacturing sector 6 months after the last hike in the cycle and the change in the unemployment rate over the following 2 years. Generally, outcomes have been poor. That said, there have been some successes, specifically the mid-1990s tightening cycle, which took some of the heat out of the economy without causing too much damage and the 2015 – 2018 cycle, which achieved the same (2) (though was quickly reversed). Achieving the same outcome this time around will be more difficult with inflation as high as it is.

Source: Refinitiv DataStream, Drummond Capital Partners

Portfolio Positioning

In a high inflation, slowing growth and rising rate environment, we expect most assets will at times struggle to generate returns. That said, now is not the time to completely withdraw from markets. We have improved portfolio quality through the removal of managers most exposed to rising interest rates and with very high valuations. We are also underweight the SAA in global equities (though remain slightly overweight the more defensive Australian market). Positioning through the rest of this year could go either way. We will reduce portfolio risk should inflation prove stubborn in a slowing growth environment, forcing the Fed to hike rates towards the more aggressive end of the spectrum. However, if inflation moderates due to improvements in supply chains (as we expect), growth doesn’t slow too sharply and the Fed tightens gradually, risk assets could continue to perform well. At this point, either path seems equally likely, so like the Fed, we will turn the dials as the outlook evolves.

(1) In practice, because of the prevalence of fixed rate mortgages and other loans,a 1% increase in interest rates by the Fed will not translate into a 1 percentage point increase in household borrowing costs. The impact will likely be less.

(2) We can’t really blame the Fed for the increase in unemployment between December 2018 and December 2020.

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