To hear Paul's thoughts, watch the interview below. A summary follows.
The next one could be around the corner or well down the road. What it does highlight going forward is that regulated banking needs to be mindful of digital liquidity of deposits – there one moment, gone the next. This has implications for their term funding models and competitiveness with non-bank lenders. In the immediate circumstances though, the Federal Reserve can refocus on their existential challenge – bringing inflation back to their prescribed inflation target ranges, with emphasis on the US and the Federal Reserve.
Despite the seemingly long-predicted demise of the US dollar and the US more broadly, all roads still and will for quite a while yet, lead to the US. In this regard, the tightening bias is still on foot now that the systemic bank crisis seems to have been averted or diverted. To recap, our assessment is:
Having failed to normalise policy in 2021 as the fiscal stimulus was overactive, the Fed is now having to raise rates ahead of data. Historically, the performance of this policy approach is poor, with rates overreaching due to the lag in the data, and hence the required evidence the Fed needs to pause and lower.
And all measures (services inflation, services wages, quit rate, hours worked) have moderated in that the “worm” has somewhat turned down, but levels and growth rates are still elevated. Services inflation and the feedback to wages, particularly services inflation, give no cause or reason for easing. Again, where the Fed wants to see evidence of (material) easing in the historical data, this risk is a tighter policy for longer.
And consumption still a positive driver for the US economy, the current monetary tightening cycle has really only impacted the marginal next house or car purchaser. The overall household is happily consuming and meaningfully contributing to aggregate demand, at odds with the Fed’s aims of monetary tightening.
The environment, therefore, supports further rises in the Fed funds rate. The data will invariably catch up and show a meaningful slowing in activity. In the meantime, the Fed may well have significantly over-raised and kept rates higher for too long. This is the nature and cost of reactionary versus pre-emptive policy. On this basis, a (moderate) recession in the US should be expected.
From an investment strategy perspective, whilst a recession in real GDP is likely, this would see nominal GDP growth reduce from 7.5% to around 5 to 5.5%, which in terms of a corporate earnings environment is still supportive, albeit with reduced growth. Combined with a likely lower US 10 year bond rate which supports valuation, we do find the US equity environment for quality businesses with pricing power and ability to efficiently leverage their fixed cost base, as attractive.
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