Dear Investors,
Macroeconomic Overview
The persistently strong labor market continues to defy the expected effects of the Federal Reserve’s increases in interest rates.
The economy added a high number of jobs again last month, and the unemployment rate remains at a historically low level.
With unemployment low, employers face more competition for qualified candidates, and that can put upward pressure on wages.
Wages are a cost to employers that can be passed along to consumers.
For that reason, wage growth has been associated with inflation, and it may be a data point being tracked for the Federal Reserve’s policy decisions.
Is arrived financial cracks, or not yet?
Banking troubles on both sides of the Atlantic were roiling markets last week.
That’s the latest fallout from the most rapid rate hikes since the early 1980s.
BlackRock has argued that bringing inflation down would be costly, creating economic damage and cracks in the financial system.
The last events will crimp bank lending, reinforcing they recession view.
As the cracks emerged, market expectations for peak rates plummeted, as the pink line in the chart shows.
The reason: hopes that central banks will come to the rescue and cut rates, as they did in the past. That’s the old playbook – and it no longer works.
Central banks are set to keep fighting stubbornly higher inflation, and use other tools to safeguard financial stability.
Case in point: The European Central Bank raised rates by 0.5% last week.
And BlackRock sees the Fed raising rates this week.
Investors need a new investment playbook and to stay nimble in this new market regime.
Macro outlook and interest rates cycle
A liquidity event in the US regional banking sector in recent days has been the catalyst for a dramatic re-pricing of the macro-outlook and interest rates cycle.
Central banks are likely to be more cautious as they monitor the tightening in credit conditions.
However, one major difference with previous banking crisis episodes is a more resilient macro backdrop including persistent inflationary pressures.
This will make for a difficult trade-off between inflation and financial stability risks, with central banks trying to resist rate cuts for as long as possible.
Pictet Wealth Management expects the Fed to hike rates by 25bp next week, to 4.75%-5.0%, but stop afterwards.
Fed chair Jerome Powell may stress again that monetary policy is working with a lag, and that recent events suggest that more tightening is spilling over to the real economy in order to justify a pause.
The Fed’s balance sheet runoff should continue at the current pace for now, although the path of least resistance would be for central banks to temporarily stop Quantitative Tightening (QT) in case of severe market dis-locations.
Tighter credit conditions
Risks of a deeper and an even earlier recession have risen meaningfully.
Recent events are already leading to tighter credit conditions, which could slow aggregate demand and become disinflationary.
With signs of deposits moving from regional banks to large nationwide ones and a rise in banks’ general risk aversion, risks of a large negative shock to consumer and business confidence and a further sharp tightening in lending standards have risen meaningfully.
It’s not the 2008 all over again
The market focus has quickly shifted from inflation fighting to shoring up the banking system.
For Nordea Asset Management comparisons to the Great Financial Crisis (GFC) in 2008 are aplenty, but most forget that the runup has been completely different this time.
The economy of the 2000s looked solid, but was to a large degree based on handing out way too much loans to people that didn’t ask for it and that had no intention or ability to pay it back.
Banks performed because their balance sheets expanded, but they were really just loaded with bad credits.
When the bubble burst, the entire foundation for this kind of growth was gone and the economy quickly turned into free fall. Banks had to take large losses, impairing their ability to provide credit.
Fed cutting rates to zero did not help, because households and businesses was focusing on paying down their debt rather than investing and spending.
This is very similar to what happened with Japanese businesses in the mid 90s.
Tightest FED policy since 1980s
The Fed has been hiking fast – that was bound to cause economic and financial damage of some kind. A comparison with the past reveals just how restrictive U.S. monetary policy is becoming.
To do that, BlackRock looks at borrowing costs in real terms, that is after accounting for the value erosion from inflation.
See the orange line on the chart.
They also account for the winding down of the Fed’s asset purchases – or quantitative tightening – as it increases the cost of borrowing.
If you translate that impact into an equivalent rate hike and add it to the real policy rate, you get the “real shadow rate.” See the yellow line.
What BlackRock thinks is that rate will reach around 2.5% by the middle of the year.
By comparison: From 2008 to 2019 the real shadow rate averaged around -3%. That makes monetary policy now the most restrictive it’s been since the 1980s when you also consider the downward trend in interest rates over the last 20 years.
It’s clear that would cause damage, even if in unexpected places. It was always the cost of getting inflation down quickly.
Employment & Consumer Confidence spending
The unemployment rate increased from 3.4% to 3.6% between January and February and remains very low by historical standards.
Part of the reason for the increase in the unemployment rate in February was the entry of 419,000 workers into the economy.
The labor force participation rate (percentage of the population wanting to work) has been moving higher and is approaching levels before COVID (the ratio was near 62.7% before COVID, it fell as low as 60.1% with the onset of the pandemic and was 62.5% in February).
Overall consumer spending increased 1.1% month-over-month in January and was up 2.4% year-over-year.
This was the strongest rate of month-over-month growth in total spending since March 2021. Spending on garments was up 3.0% month-over-month and was up 3.2% year-over-year.