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Good morning. Ethan here; Rob’s away this week.
By 2022 standards, yesterday would’ve been just another day of bear-market selling. But after a euphoric January, a 2 per cent down day for the S&P 500 feels sombre. The clearest cause is the return of interest rate volatility, as markets start to believe the Federal Reserve really will raise rates to high heaven. The S&P peaked on February 2, a day after the Move index, a measure of rate volatility, bottomed. The Fed is still the biggest story in markets, and it isn’t close. Email me: firstname.lastname@example.org.
Corporate America is still investing
Answer this with one word: why has the US economy stayed strong? Our pick would be “consumers”. Buoyed by a structurally tight labour market and a still-intact pandemic savings cushion, consumers, who make up some 70 per cent of nominal gross domestic product, are powering through rate rises.
But a good runner-up might be “corporations”. Business investment (something like a fifth of GDP) has likewise withstood higher interest rates. In the fourth quarter, S&P 500 companies grew capital expenditure 10 per cent year-on-year after adjusting for inflation, estimates Spencer Hill at Goldman Sachs. The nominal figure is a rollicking 17 per cent. There is talk of a “capex supercycle”.
The backstory is that companies used the Covid stimulus to tidy up their finances, leaving behind a nice cash pile. Pantheon Macroeconomics puts the leftover cash buffer at about $400bn, compared to the pre-Covid trend. Meanwhile, balance sheets have gotten cleaned up and debt maturities pushed out well into the future. Many think this is blunting the immediate impact of rate increases on businesses.
Higher rates still do bite, however. As we’ve written before, revenue growth is slowing and margins are compressing. But looking across the universe of US companies, Goldman’s Hill sees most cost cuts coming from a less-discussed source:
So far, companies appear to be responding to lower margins and higher financing costs by cutting share buybacks — which fell 12 per cent in the [fourth] quarter — as opposed to reducing investment or employment.
After months of news about job cuts and cost reductions, this explanation feels unintuitive, but it may better match the macro picture of steady capex growth and rock-bottom unemployment.
Yet unless margin pressure abates, it’s hard to see investment being insulated for ever. If it gets cut, is the economy in trouble?
The 2015-17 default cycle offers a useful comparison. Driven by a commodity downturn, it’s not a precise analogy (it rarely is). But it is a good example of a non-recessionary contraction in capex. Here’s what business fixed investment did during that period:
A sector-specific bust created four quarters of contracting investment. But since (real) consumption spending kept chugging along at a 2.8 per cent rate, a recession was avoided.
Maybe the fact that investment can shrink without causing a recession makes you more willing to believe in a soft landing. Or maybe it makes you think inflation is pretty darn entrenched (we’re sympathetic). The point is that despite real signs of slowdown building on the margins, the Fed faces an economy that isn’t just being pulled along by consumers. At its core, strength abounds.
Will the Fed stick to 2 per cent?
A few readers have recently written in to voice their suspicion about the Fed’s commitment to a 2 per cent inflation target — which Unhedged has often taken as a given. They think the US central bank is going to abandon the target the moment it is expedient to do so.
Markets don’t discount the possibility. The five-year break-even, a proxy for market inflation expectations, sits at 2.6 per cent, compared with a 2003-19 average of 1.8 per cent. Survey measures aren’t much different; the New York Fed’s five-year expected inflation rate is 2.5 per cent.
This looks consistent with the Fed reaching 3ish per cent inflation and deciding, well, close enough. It’s not hard to see why. As we’ve written before, the first leg of disinflation is probably going to be easier than what comes after. Consider that core inflation has taken a big step down — from a 0.6 per cent monthly pace in mid-2022 to 0.4 per cent in January — with no increase in unemployment. But it may get uglier. In a recent note, Don Rissmiller and Brandon Fontaine at Strategas write:
Elevated job openings & consumer cash holdings are providing cushions now. But the last -1 per cent reduction in inflation (from 3 per cent [headline consumer price index] to 2 per cent) could be very expensive in terms of job loss. Perhaps a 6-7 per cent unemployment rate is needed (more consistent with historical US recessions).
As job losses, and political pressure, mount for the Fed, Rissmiller and Fontaine think it will consider lowering the bar:
Pushing all the way down to a 2 per cent number, which is chosen arbitrarily anyway, may not be credible. Declaring mission accomplished in the neighbourhood of 2 per cent provides the best hope of a “soft-ish” landing for the economy that we see going forward. The Fed declaring victory at 3 per cent, as long as 3 per cent looks anchored, would mean short rates could have a 3-handle in 2024 (as policy moves back towards neutral).
This account seems plausible enough, especially since prominent voices are already calling for the 2 per cent target to go.
But it also assumes the Fed knows at what level interest rates become restrictive, and thus has precise control over inflation and unemployment. It seems more likely to us that the Fed is feeling around in the dark. Yes, the central bank can always cut if it goes too far, but easy monetary policy exhibits long and variable lags, too. We would humbly offer up another scenario: by the time the central bank realises it has overtightened, it’s already too late.
One good read
Scott Alexander revisits his predictions about 2023, made in 2018.
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