Just 12 months into the fastest interest-rate hiking cycle in history – and yet neither western stock markets nor economies are thus far showing the weakness that was expected.
Inflation in the US has fallen for 11 straight months whilst maintaining full employment. The EU and UK haven’t been as successful in clamping down on inflation, but the signs are that it has at least peaked.
European stock markets are at all-time highs, unemployment at all-time lows. But this positivity could be as good as it gets, as this twin strength in asset and jobs markets could see interest rates at least stay at, or even rise from, these elevated levels for even longer to definitively banish post-Covid inflation.
This could prove a challenge for markets which lack the attractive valuations of last summer. It could also exacerbate the nascent real estate and regional banking crisis in the US.
Monetary policy acting with a lag is an insufficient explanation for the strength of global markets and economies. Macro prudential regulations brought in after the great financial crisis worked in providing economic stability, but have made the job of central banks harder.
‘Those on fixed-rate products will not feel the impact for a number of years’
Measures ranging from the capital standards at European banks to the LTV requirements of domestic mortgages holders have resulted in initially less cyclical exposure to rate rises.
The proportion of homeowners on fixed-rate mortgages has increased dramatically, concentrating the distressing impact of sudden rate rises in fewer homes and limiting the overall impact of rate rises on the economy in aggregate. Those on fixed-rate products will not feel the impact for a number of years, delaying the impact.
Post-Covid savings have not only cushioned the cost-of-living crisis and kept spending high, but recent data in the EU has indicated that the benefit to savers of rising interest rates has so far been greater than the hit to mortgage holders.
Such is the supply/demand housing imbalance in the US that there are signs that – despite mortgage rates going from 2pc to 7pc – US housing activity is actually picking up. The US is in danger of becoming the Icarus economy. The wax wings of Bidenomic industrial policy and consumer strength has seen its stock market soar, structural factors thus far clearly offsetting the cyclical impact of rate rises.
But the easy drop in inflation is behind us. Central banks are left with economies with full employment and inflation still at least double their mandate. It becomes more difficult for inflation to continue its downward trend, as it is now being driven by the service sector.
The current rate of 5pc to 5.5pc may have to persist, as the Fed has been vocal in not wanting to see inflation re-accelerate before it even reaches its target. This would leave investors with a big decision: why take a risk with any other asset class, when the US government offers a risk-free return of over 5pc?
When you factor in that equities are as expensive, relative to bonds, as they have been this century – and they’ve already rallied 20pc to 40pc off their lows – the risk-free yield looks difficult to walk away from. Europe and the UK see a similar dilemma, with risk-free rates of between 4pc and 6pc for the first time in over 20 years.
‘Higher-for-longer interest rates bring back into play the threats surrounding global commercial real estate and banking deposit flight’
This is sowing the seeds for a less positive backdrop into the second half of the year.
The wax wings of a resilient economy and booming markets may be melted by the elevated rates they are fanning.
Higher-for-longer interest rates bring back into play the threats surrounding global commercial real estate and banking deposit flight, as well as increasing the chances of a policy error – as central bankers, emboldened by their success thus far, risk over tightening to comprehensively tame inflation.
This could manifest itself as a sudden slowing in global growth as the culmination of high rates hit home, or as another market crisis (akin to the LDI UK pension crisis or the Silicon Valley bank failure) as misunderstood leverage comes to the fore.
Other global issues abound. The Bank of Japan is about to embark on its own policy normalisation and China’s reopening of their economy has brought their property crisis back onto the radar. Luckily for investors, they can earn a solid return on cash whilst waiting to find out how conflicting and contrasting forces play out over the next few months.