Coming into this year, there was speculation of a potential recession. Why do you think the economy has been so resilient this year?
Fears of an imminent U.S. recession have lingered for several months now; at times, the recession was all but a foregone conclusion for many investors. These worries have valid historical precedent. In the past, a Fed funds rate of 5.4% after 11 rapid rate hikes would have been significantly restrictive in slowing the economy down.
And yet, the U.S. economy has proven to be surprisingly resilient so far. We believe several unusual factors are at play in this post-pandemic recovery. We have long held the view that the U.S. economy is now less rate-sensitive than ever before. After a long period of ultra-easy monetary policy, consumers and corporations alike have locked in low fixed rates well into the future. They are, therefore, more immune to rising rates than they were in the past.
The U.S. consumer has also been supported by a fairly solid jobs market. Despite the recent significant downward revisions in jobs data, monthly jobs growth has still averaged more than 220,000 in the last one year. The rise in the unemployment rate is still below the dreaded 1% threshold and the absolute level of unemployment is still low by historical standards. We note that employers have hoarded labor in the post-pandemic economy to prevent disruptions; we expect this trend to continue.
And finally, we trace the resilience of the U.S. consumer to two unexpected sources of support. Even though incomes and spending have started to deteriorate, the high-end consumer has been buoyed by a significant wealth effect and low debt burdens. The strength in the housing and stock markets has catapulted consumer wealth into its highest historical decile. The prolonged deleveraging that took place after the Global Financial Crisis has also left U.S. households with relatively low debt.
We may yet avoid a recession in the coming months from the following shifts in trends.The pandemic brought about a significant loss of incomes, which was effectively countered by fiscal policy support. The resulting tailwind of excess savings helped fight off the headwinds of high inflation and interest rates in the last two years. And now, as we deplete those excess savings, low inflation and interest rates are poised to inflect and become tailwinds on the path to a soft landing.
Over the course of this year, the markets have been trying to price in rate cuts — oscillating between a single cut and multiple cuts this year. As the Federal Reserve continues to assess economic data, can you speak to the importance of correctly timing the first rate cut? Has the Fed already missed its moment?
The Fed has often committed to a higher-for-longer stance in the last several months. As long as growth was resilient, the Fed had the option to remain patient and keep rates high. Indeed, their policy was largely focused on avoiding the mistakes of the late 1970s. If they were to ease too soon, a potential surge in economic activity might rekindle inflation and send it higher.
Recent economic data, however, is now beginning to reverse. The last couple of months have seen renewed evidence of cooling inflation, a weaker job market and a softer economy. As growth deteriorates and inflation heads lower, the risks of waiting too long now clearly outweigh the benefits of being patient. Several sectors of the economy remain vulnerable to the prolonged impact of higher interest rates. These include the highly leveraged private equity and commercial real estate businesses and the less regulated private credit markets. The balance of risks has now tilted towards growth and away from inflation; the time has come for the start of a new easing cycle.
Our view on future monetary policy has remained largely unchanged through the year even as the market expectations for rate cuts gyrated all over the place. We have felt all along that falling inflation and a slowing economy would allow the Fed to cut rates sooner and more frequently than it believed or the market expected. Along the way, we also formed a view that the new neutral rate for the new post-pandemic economy was 3.1%, which would allow the Fed to make eight to nine rate cuts.
As we did before, we expect three to four rate cuts in 2024, five to six in aggregate by March-April 2025 and all eight to nine by the beginning of 2026. We have believed that the Fed could have started in July; however, a September start doesn’t leave the Fed hopelessly behind with no chance to correct course. It is inconceivable to us that the Fed would hold off any longer. If they do so for any reason, it would be a major policy misstep.
What are the market trends you are watching?
Growth is clearly slowing and has yet to bottom out. We expect that it will subside to below-trend levels, but still remain positive. We recognize that it is always hard to achieve a soft landing in the economy. We are intensely focused on any sign of unusual weakness in the jobs market, for instance, unexpected layoffs, early increases in weekly unemployment claims or a sharp drop-off in monthly jobs growth.
Given fairly high valuations, we also recognize that the stock market has a low margin for error. We are confident that high earnings growth expectations will be achieved; however, we are vigilant for any canaries in the coalmine that spell trouble for corporate profits.
Geopolitics and the U.S. elections carry their own set of risks. We are on the lookout for any escalation of geopolitical tensions that threaten global growth or any signs of an election outcome that results in fiscal profligacy without a corresponding growth impetus.