The issue of optimism

The issue of optimism

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Good morning. This week will see a series of post-meeting Fed talks, culminating with Jay Powell speaking at the IMF on Thursday. We expect opinions on the economy to vary widely. “This is a point of minimum — not maximum — confidence,” Joseph Gagnon of the Peterson Institute told the Financial Times last week. If your confidence is at the limit, give us your opinion: robert.armstrong@ft.com and ethan.wu@ft.com.

Can the good times last?

Praise for the work of other financial journalists causes real, unprotected pain. But we will bear the pain when a reputable newspaper makes itself a hostage of fortune, making unambiguous predictions and defending them with zeal. That’s what The Economist magazine did late last week, in its article “It’s Too Good to Be True.” It clearly states that high interest rates will ensure “the failure of current economic policies, as well as the failure of the growth they have fostered.”

For people who don’t work in the field of clairvoyance, a post that simply states what they think will happen may not seem very impressive. Those of us who work in this field (whether willingly or unwittingly) know that the urge to hedge or make a prediction conditional can be irresistible. Hence the name of this leaflet, which aims to rebuke its authors, and only works sometimes.

The Economist’s argument is that (a) households will soon run out of excess savings, and when that happens, higher interest rates will hurt (b) companies are already feeling the pain on profit margins, as rising bankruptcies show (c) housing prices will fall before… Given a long time, (d) banks will have to fill the hole that higher interest rates have created in their balance sheets, and (e) higher interest rates will make it impossible to maintain current levels of financial generosity.

It would be better if we categorically disagreed with this argument, but we don’t. Our central forecast, like theirs, is that “the longer bullish era is killing itself, by creating the economic weakness that allows central bankers to cut interest rates without inflation skyrocketing.” This is why, for example, we have discussed (albeit tentatively) accepting duration exposure in fixed income.

But we believe there is more room for optimism than The Economist allows. They claimed, somewhat simplistically, that a sharp decline was inevitable; To delay a recession, not avoid a recession. We believe there is still a path to a soft landing.

There is little evidence, we’ll admit at the outset, that the pessimistic view is actually coming true. Friday’s jobs report showed slowing payroll growth and, more worryingly, a rise in the unemployment rate to 3.9 percent, from a recent low of 3.4 percent. This does not constitute a recession, but it is a disappointing development. The “arrow” rule says that every recession historically begins with the three-month average unemployment rate rising by 0.5 basis points above the baseline in the past year. Today’s three-month unemployment trend is 0.33 points above the baseline. Some other data looks pessimistic as well. The latest ISM surveys of manufacturing and services activity are weak. Consumer confidence is falling again.

Interest rates could actually be more challenging next year. Corporate debt was eliminated in 2020-2021, but not indefinitely. The amount of outstanding corporate debt will rise from $525 billion this year to $790 billion in 2024 and more than $1 trillion in 2025, according to Goldman Sachs. Paying off student loans will create a small but permanent drag on consumption. Interest payments already exist. The share of total spending taken up by personal interest payments rose 40 percent year-on-year, to nearly 3 percent of consumption.

However, we still believe there is room for continued growth over the next year and beyond. Here’s how to respond to points (a) through (e):

Excess savings will soon be exhausted. The concept of excess savings is too imprecise and subject to measurement issues to help call a turning point in the economy. The pooling of surplus savings ignores crucial distributional differences. By all measures we have seen, excess savings were mostly accumulated by households with the highest incomes. Some low-income households may have already run out of savings, as evidenced by rising mortgage delinquencies and sporadic signs of tension among companies and lenders serving the lower end of the income/wealth spectrum. As we have noted, the household saving rate appears to be declining.

However, it is difficult to distinguish between tension and normalization in the wake of the post-pandemic boom. However, the news is not all bad. National data on wages and household budgets are encouraging. The Fed’s latest survey of consumer finances, based on data from 2019 through the end of 2022, found “broad improvements in U.S. household finances.” Net worth rose and non-mortgage debt declined, except for the bottom wealth quintile, where it remained flat. It is precisely this additional wealth that The Economist believes will be squandered. maybe; But households will enjoy stronger real incomes. Average real incomes rose modestly over this period, and the wealthy fared better than others; But all kinds of people made gains, rich and poor, young and old, city and country, and across ethnic groups (unfortunately, the lack of a college degree remained a barrier to wage gains). This increase in real wage gains continues until 2023.

In short: saving is not everything. Income is also important, and appears to be on sound footing.

Companies are already feeling the pain. Granted, we’re American citizens here at Unhedged; This is a US-focused newsletter by design. But from where we sit, companies, especially the larger ones, look good. It would be very strange if interest rates rose by 5 percentage points and no highly indebted companies were hurt, but given current trends, what is striking is how little the increase has been so far. Bankruptcy rates will be high this year, according to current trends, but not catastrophic. Chart from S&P Global, through September:

Part of the reason for this is that companies make money. Large public companies aren’t necessarily a representative sample, but with four-fifths of the S&P 500 reporting third-quarter results, revenue and profits are growing in the low single digits versus strong results a year ago, according to FactSet. Yes, corporate targets for next quarter were a bit dovish, but given the sentiment management is picking up from volatile markets, no one can blame them.

Real house prices will fall soon. The Economist asserts that this will happen “because they rely mostly on buyers who borrow again, and thus face much higher costs.” This ignores supply, which is severely restricted in the US (among other places). Blame a decade of under construction and high interest rates that have locked people into low-interest mortgages. The result is that although mortgage affordability is the worst it has ever been, by some measures, US home prices have risen 6 percent this year after just seven months of decline. This is equivalent to twice the speed of headline inflation.

The best way to think about the impact of higher interest rates is to reduce demand for housing, analysts at Bridgewater said. Even at mortgage interest rates of 8 percent, demand for housing still exceeds supply, but the gap would still be larger if interest rates were lowered. What could push home prices down is forced sales, if a weaker labor market pushes the foreclosure rate higher. Apart from that, the decline in prices may also be due to overbuilding in booming cities like Phoenix. But both are about supply, not demand.

Banks will have to raise capital or merge. From the point of view of US banks, we are not particularly worried about this. We conducted a massive interest rate risk exercise in March, examining every balance sheet in the industry for unbearable market losses on long-term assets with fixed interest rates. A few banks failed the test and disappeared. It is now recognized that a greater number of investors have long-term profits from non-saleable assets that earn below market prices. Bank stocks are just as cheap now, which makes sense. But unless there is another significant rise in long-term interest rates, a major round of capital raising seems unlikely (regulators may require larger capital cushions, especially from big banks, but that is a separate issue). If the concern is loan growth, demand for bank credit may be a greater constraint than weak bank balance sheets; Non-bank lenders, with billions to operate, are seeking loans to buy them.

The financial largesse must end soon. We’re not political reporters, but the obstacles to some sort of fiscal consolidation in a divided Congress during a presidential election seem formidable. We agree that there is an urgent need to raise taxes and cut spending, but this may not come to fruition soon enough to matter in this cycle.

What we mean here is that it is still possible to repeat the main intellectual mistake we made over the past eighteen months: underestimating the importance of the American economy. (We were guilty of this too!)

Again, we do not want to overstate our disagreement with The Economist. What we see is a real chance for a soft landing, not the possibility of it happening. History says that when interest rates jump, recessions tend to follow. In fact, the global outlook looks bleaker than that of the United States. But, especially if the next few inflation reports show further deceleration, the Fed can announce its resignation now or after one or two interest rate hikes, a recession could be avoided. (Armstrong Wu)

One good read

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