Shutting The Front Door On Future Hikes
Ask Forstrong: Is the Fed done hiking rates?
The Fed has concluded its rate hiking cycle.
But investors positioning for aggressive rate cuts in 2024 are also betting on a hard landing. That is an unlikely scenario.
Asset classes geared toward a “no landing” scenario with higher-for-longer growth and inflation now offer tremendous value: banks, commodity plays, and especially international value stocks. Cash and bonds will colossally underperform.
What do you do when a climate protestor interrupts your speech on monetary policy? For the normally poised Fed Chairman Jerome Powell, likely unaware his lapel mic was still live, it involved bluntly telling an aid — paraphrasing here — to just shut the front door. Rarely do we hear that candor from central bankers. Check out the viral memes for some light entertainment.
Elsewhere, other doors are quickly closing too. Forecasts of doom for 2023 can now be pronounced dead wrong. The global economy is simmering down but recession is not yet in sight. Employment growth is slowing but still secularly tight. Corporate profit growth has stabilized. Emerging markets like India and Brazil have been bright spots. Seen from the 50,000-foot macro view, this remains a picture of resilience. Who had all that on their bingo card at the beginning of this year?
Looking ahead, the biggest question for markets is the trajectory of monetary policy. Here, it is becoming clear that the world’s major central banks have finished hiking rates. Most pandemic-related supply chain distortions have run their course. The lagged effects of higher interest rates, at long last, are finally showing up: financial conditions have tightened and labour markets have softened somewhat. Powell won’t yet say it (at least not when his mic is on) but interest rates, now at a 22-year high in America, are roughly at the right levels.
But believing that interest rate hikes are done is different than believing a deep rate cutting cycle is in the cards for 2024. Yet this is exactly what is unfolding. Bank of America’s recent global fund manager survey reveals that a record 80% of respondents expect lower short rates next year, with bonds predicted to be the best performing asset class. Translation? A strong consensus is expecting a return to the low interest rates of the 2010s. That is a big bet. Consider what it would take for those forecasts to be proven accurate: collapsing growth and a large rise in unemployment. In other words, a hard landing with a return to sub 2% inflation.
But how likely is that scenario? On the surface, we understand the view. Many look back wistfully on the 2010s as a kind of economic nirvana with the basic argument that if low rates boosted asset prices, then naturally, higher interest rates should depress valuations and wreak havoc on the economy. That symmetry is seductive. And higher interest rates are indeed hammering certain asset classes where the most leverage and credit excess took place over the last decade. Cryptocurrencies and profitless tech, fueled by near-free money, have already collapsed. Commercial real estate is in recession. Canadian housing, along with other developed markets that did not deleverage in the 2010s (the UK, Sweden, Australia, etc.), are facing falling prices. And the massive wave of capital that flowed into private markets are now facing a painful price discovery process (read: much lower).
But these are all relatively limited pockets of global markets. Commercial real estate is a wealth shock, but the impact on consumption will be limited as owners are skewed toward institutions, pension funds, etc. Housing in weak-link economies will likely produce recessions but these countries collectively account for only about one-tenth of global GDP. Healthy wage gains will also help offset the downside here. Finally, the fallout from private markets will have limited contagion on the broader banking sector as regulatory reform after 2008 forced them away from speculative lending.
Looking back, the low interest rate 2010s were merely a reflection of slow growth and low inflation. Deleveraging in America and the Eurozone was the main event. Many forget that the global economy limped through the 2010s, with only a few asset classes doing well.
Contrast that decade with today’s outlook. Both growth and inflation are set to remain higher for longer. America and the Eurozone have far healthier household balance sheets. In Asia, even though China’s blistering GDP growth rates are over, pessimism toward the country is overdone. Incoming economic data in recent months is now starting to consistently surprise on the upside. Collectively, China, America and the Eurozone account for some 80% of global GDP. Deep downturns are unlikely, particularly if rate hiking cycles are over.
The deflationary impulses that defined the 2010s decade are also no longer in place. After the global financial crisis of 2008, fiscal austerity provided a persistent disinflationary trend. Capital spending in the private sector was also sparse. The investment that did take place mainly went into productivity-dragging distractions — digital games, social media and other consumer internet technology. And, of course, the 2010s were the decade of massive share buybacks. None of this made a meaningful contribution to overall economic growth.
Looking ahead, a revival in demand is taking hold simply because the world has underinvested in the productive capacity of the economy for years (what our investment team calls the “revenge of the real economy”). Supporting all of this is government deficits and an enormous appetite for fiscal spending, whether it is for healthcare, energy, or infrastructure. Heightened geopolitical tensions are also leading policymakers to spend more on industrial policy. In fact, a global race to reindustrialize — driven by decarbonization, reglobalization and remilitarization — is underway.
All of this is reversing the “secular stagnation” trend of the last decade and powering an environment of structurally higher growth and inflation. Yet, in the same way that it took investors a decade after the 1970s to believe that the interest rate environment had changed, it will take years for investors to believe that the zero rates of the 2010s were an aberration.
The peaking out of interest rate hiking cycles around the world will extend the bull market that bottomed in October 2022. During the last 8 rate-hiking cycles in Canada, risk assets soared after the last hike (measured over 1 and 5-year periods). Cash always underperformed.
But which risk assets should global asset allocators buy? Betting on longer-dated bonds is a big gamble. Inverted yield curves and record sums sunk into fixed income funds suggest that everyone has already run into the trade.
By contrast, many investment classes that struggled with chronically weak demand and dismal pricing power in the era of low inflation, are primed for a long period of outperformance: sectors with pricing power (banks, industrials, healthcare), select resource-exporting emerging market equities and international value stocks which trade on far lower multiples and far higher dividend yields. Investors shouldn’t shut the front door on those exposures.