Investors should act as if the Fed put is no longer in place
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The writer is global chief investment officer at Credit Suisse
In keeping with a fine financial industry tradition, this is the time of year for prognostications of the health of the world economy and what to do with the collective wisdom of investors.
Trawling through the economic and investment outlooks of the various banks and asset managers, many have noticed an overwhelming consensus for a recession this year in the world’s largest economy.
According to this script, a recession in the US in 2023 should lead to a rapid deceleration in inflation thereby allowing the Federal Reserve to stop hiking rates and then — at a later stage — to start cutting rates to get us out of trouble. This script is a familiar one seen in the US recessions of the early 1990s, 2001 and 2008. What invariably follows is a market rally in equities, and investors live again for another cycle.
It feels somewhat uncomfortable, however, that both market observers and market participants are presently converging on this rather optimistic assessment, not least because broadly held consensus market views are usually dead wrong. We must be missing something. So, what could go wrong with this script? At what point do we go from “this time it’s the same” to “this time it’s different”?
There are powerful reasons for the consensus expectation. Growth has already slowed rapidly. The eurozone and the UK are already in recession and growth in the US has slowed to a trickle. US inflation has peaked and the Fed is adamant in its fight against it, meaning it could decline further. This economic view is also firmly priced in by financial markets.
The most visible sign is certainly the deeply inverted yield curve where rates on short-term bonds are higher than for longer maturities. Since the 1960s, this has been a reliable predictor of an impending recession. At the same time, an inverted yield curve is also a reflection of the expectation by market participants that inflation rates are likely to fall and that the central bank will — at some point — cut interest rates to support growth again or calm down market turmoil. The fact that the curve is so deeply inverted right now, therefore, also means that investors expect inflation to normalise quickly and that the Fed might be able to cut rates sooner rather than later.
Yet, there are also factors that speak against the current consensus expectation which are worth considering. First, when it comes to growth, a US recession could come significantly later than many expect. The US economy is not as exposed to Fed rate hikes as in the past. Nowadays, homeowners mostly hold fixed-rate mortgages and corporations have used the low interest rates of the past years to finance for the long term.
Households and companies will feel the impact of rate hikes with a longer lag than usual. So, while growth is weak already, the fall into an outright recession might be like waiting for Godot. This is in stark contrast to the quick recession/quick recovery pattern that markets seem to expect.
Second, when it comes to inflation, it could turn out to be more entrenched than expected. Wage growth inflation in particular seems sticky due to a shortage of skilled workers. The new multipolar world order will enforce structural changes to the economy, such as the need to rebuild reliable supply chains closer to home, which often comes at higher prices. Similarly, the urgent need to decarbonise could exacerbate “greenflation”, that is, rising prices for eco-friendly goods and services.
All of this means that inflation rates could decline much more slowly than many of us (including central banks) would like. The Fed may end up in a situation where it will have to keep interest rates up due to inflation — even as a recession starts.
This would be negative for equity markets, as the initial market rebound following a recession is often triggered by rate cuts. The Fed “put” — the willingness of the Fed to support markets in times of volatility — would be gone for good and the way out of recession would be fiscal and not monetary.
These reasons make the current market consensus very uncomfortable. We risk being in a longer period of poor growth, elevated inflation and weak equity markets than during past slowdowns. Investors would thus be well advised to keep portfolios diversified, including a sensible allocation to fixed income. Alternative investments such as hedge funds or private equity could also be a way to manage portfolio risks.
In fact, investors should continue to be cautious into the next year and act like the Fed put is no longer in place. That would mean that this time, it really is different.