The case for optimism

Good morning. This week will bring a string of post-meeting Fedspeak, culminating with Jay Powell talking at the IMF on Thursday. We expect opinions on the economy to diverge widely. “This is a point of minimum — rather than maximum — confidence,” as Joseph Gagnon of the Peterson Institute told the FT last week. If your confidence is at a maximum, lay an opinion on us: robert.armstrong@ft.com and ethan.wu@ft.com.

Can the good times last?

It causes Unhedged real anguish to praise the work of other financial journalists. But we will endure the pain when a reputable publication makes itself hostage to fortune, presenting an unambiguous prediction and arguing for it with gusto. This the Economist did late last week, in their leader “Too good to be true”. It states plainly that high rates will ensure that “today’s economic policies will fail and so will the growth they have fostered”. 

For people who are not in the foresight business, a publication simply stating what it thinks is going to happen may not appear impressive. Those of us who are in the business (willingly or unwillingly) know that the urge to hedge or conditionalise a prediction can be irresistible. Hence the name of this newsletter, which is meant to admonish its authors, and only occasionally works.

The Economist’s argument is that (a) households’ excess savings will soon be exhausted, and when they are, higher rates will bite (b) companies are already feeling the pain at the margins, as rising bankruptcies show (c) house prices will fall before long (d) banks will have to backfill the hole higher rates have opened in their balance sheets and (e) higher rates will make current levels of fiscal largesse impossible to maintain. 

It would make better copy if we flatly disagreed with this argument, but we don’t. Our central forecast, like theirs, is that “the higher-for-longer era kills itself off, by bringing about economic weakness that lets central bankers cut rates without inflation soaring.” That is why, for example, we have argued (however tentatively) for taking on duration exposure in fixed income.

But we think there is more room for optimism than the Economist allows. They have argued, to simplify somewhat, that the hard landing is inevitable; for recession delayed not recession avoided. We think there is still a path to the soft landing. 

There is a smattering of evidence, we’ll admit at the outset, that the pessimistic view is already coming true. Friday’s jobs report showed payroll growth slowing and, more troublingly, the unemployment rate rising to 3.9 per cent, from a recent nadir of 3.4 per cent. That isn’t recessionary, but it is a discouraging development. The Sahm rule says that every recession has historically begun with the three-month average unemployment rate rising 0.5pp above the baseline of the past year. Today’s three-month unemployment trend is 0.33pp above the baseline. Some other data looks downbeat too. The latest ISM surveys of manufacturing and services activity are weakening. Consumer confidence is falling again.

Interest rates could indeed bite harder next year. Corporate debt was termed out in 2020-21, but not to infinity. The amount of corporate debt maturing will rise from $525bn this year to $790bn in 2024 and over $1tn in 2025, according to Goldman Sachs. Student loan repayments will create a small but lasting drag on consumption. Interest payments already are. The share of total spending taken up by personal interest payments has risen 40 per cent year over year, to nearly 3 per cent of consumption.

Yet we still think there is space for growth to continue through next year and beyond. Here is how we respond to points (a) through (e): 

Excess savings will soon be exhausted. The concept of excess savings is too imprecise and too vulnerable to measurement issues to help call a turning point in the economy. Aggregating excess savings glosses over crucial distributional differences. By all measures we have seen, excess savings were mostly accumulated by higher-income households. Some lower-income households may already have run out of savings, as evidenced by rising subprime auto delinquencies and scattered signs of stress among companies and lenders that cater to the low end of the income/wealth spectrum. And, as we’ve noted, the household savings rate does seem to be falling. 

It is hard, though, to tell stress from normalisation following the post-pandemic boom. And in any case the news isn’t all bad. The national data on wages and household balance sheets is encouraging. The Fed’s latest Survey of Consumer Finances, based on data from 2019 through the end of 2022, found “broad-based improvements in US family finances”. Net worth has surged and non-real estate debt fell, except in the lowest wealth quintile, where it is flat. It is precisely this additional wealth that the Economist thinks will still dissipate. Perhaps; but households will still have stronger real incomes. Mean real income rose modestly over the period, and the already rich did best; but all sorts of people experienced gains, rich and poor, young and old, city and country, and across ethnic groups (lack of a college degree, unfortunately, remained a barrier to wage gains). And this increase in real wage gains has continued into 2023. 

In short: savings are not everything. Incomes matter too, and they appear to be on sound footing. 

Companies are already feeling the pain. Admittedly, we are American provincials here at Unhedged; this is a US-focused newsletter by design. But from where we’re sitting, companies, especially bigger ones, look to be in fine shape. It would be very odd if interest rates rose by 5 percentage points and no over-indebted companies hit the rocks, but looking at current trends, what is notable is how small the increase has been to date. Bankruptcies will be high this year, on current trends, but not disastrous. Chart from S&P Global, through September:

Part of the reason for this is that companies are making money. Large, public companies are not a representative sample, necessarily, but with four-fifths of the S&P 500 reporting third-quarter results, both revenues and earnings are growing in the low single digits against strong results a year ago, according to FactSet. Yes, companies’ targets for the next quarter have been a bit cautious, but given the vibes management must be picking up from volatile markets, one can’t blame them.  

Real house prices will fall before long. The Economist asserts this will happen “because they depend mostly on buyers who borrow afresh, and therefore face much higher costs”. This ignores supply, which is severely constrained in the US (among other places). Blame a decade of under-construction and high rates locking people into low-rate mortgages. The result has been that even though mortgage affordability is by some measures the worst on record, US house prices have risen 6 per cent this year after a mere seven months of decline. That is twice as fast as headline inflation. 

The better way to think about the effect of high rates is as a lid on housing demand, as analysts at Bridgewater have argued. Even at 8 per cent mortgage rates, housing demand still exceeds supply, but the gap would be still larger if rates were cut. What could reduce house prices are forced sales, in the event that a weaker labour market pushes up the foreclosure rate. Short of that, falling prices could also be caused by overbuilding in boom towns like Phoenix. But both of these are about supply, not demand.

Banks will have to raise capital or merge. From the point of view of American banks, we are not particularly worried about this. We had a massive interest rate risk fire drill in March, where every balance sheet in the industry was checked for unbearable mark-to-market losses on long term, fixed rate assets. A few banks failed the test and are gone. A larger number are now recognised to have a long-term earnings drag from unsaleable assets that earn below-market rates. Bank stocks are correspondingly cheap now, and this makes sense. But barring another very big step up in long rates, a major round of capital raising seems unlikely (regulators may ask for bigger capital cushions, especially from the largest banks, but that is a separate issue). If the worry is loan growth, demand for bank credit may be a bigger constraint than banks’ weak balance sheets; non-bank lenders with billions to put to work are panting for loans to buy.    

Fiscal largesse must end soon. We are not politics reporters, but the barriers to some sort of fiscal consolidation in a divided congress during a presidential election seem formidable. We agree that urgency is building to raise taxes and cut spending, but it may not come to fruition soon enough to matter to this cycle.

Our point is that it is still possible to repeat the key intellectual mistake of the past 18 months: underrating the US economy. (We were guilty of this, too!) 

Again, we don’t want to exaggerate our disagreement with The Economist. What we see is a substantive chance of a soft landing, not a likelihood of one. History says when rates leap, recessions tend to follow. And the global outlook indeed seems dimmer than the US one. But, especially if the next few inflation reports show further cooling, so the Fed can call it quits now or after one or two more rate increases, recession can be avoided. (Armstrong & Wu)

One good read

A defence of active fund management.