The cost of capital has returned to normal over the past year and after last year’s setback, expected returns have significantly moved upwards across the entire risk and currency spectrum. Overall, the balance between risks and opportunities is much better at the beginning of this year than at the same time last year. There is yield in portfolios again – a situation we have not seen in almost 10 years.
The US economy continues to prove its resilience
One of the most striking features of 2022 was the seeming indifference of the US economy to changes in policy rates. Its ability to withstand 425 basis points of rate hikes in only nine months without something breaking along the way is nothing short of remarkable. In hindsight, this is mainly due to the strong financial position of the US private sector.
US households can still draw down pandemic-induced excess savings, while debt service burdens are historically low thanks to a decade of low interest rates. As a result, consumer spending in the US is back to pre-pandemic levels, even when adjusted for inflation. The listed US corporate sector, for its part, can still rely on nearly 90% of its debt being financed at fixed rates with an average maturity of seven years. Clearly, it will take some time for higher interest rates to work their way through to corporate financing costs.
Inflation is much better than it looks
On the inflation front, it is worth mentioning that year-on-year rates obscure the progress made below the surface in recent months. In fact, US inflation fell dramatically in the second half of 2022. The latest US headline inflation print for December marked the sixth straight monthly deceleration. Irrespective of the headline inflation measure chosen, the annualised growth rate has broadly decelerated to below 2% over both the last three and six months.
Admittedly, lower food and energy prices were the biggest contributors to the decline, and it remains to be seen whether the recent volatility in these inflation components has permanently subsided. However, the improvement comes at a time when the Fed’s tightening measures have hardly yet been transmitted to the real economy. Instead, the supply-chain bottlenecks have now largely dissipated, leading us to conclude that the ‘transitory inflation’ camp of early 2022 may not have been entirely off the mark after all.
The Fed does not want risk assets to recover for the time being
Nonetheless, the Fed is currently facing both a problem and a constraint. The problem is that the American monetary institution had been fighting the challenge to avoid deflation for two decades, and now it is afraid of being discredited. It is willing to accept anything, even a recession, to put inflation back in its box. On the other hand, in this epic battle against post-pandemic inflation, the Fed is also constrained by the US electoral agenda, as 2024 is a presidential election year.
The economy simply cannot fall into a recession at a time in which the campaign for the White House is in full swing. Thus, the Fed must keep a lid on prices now. It will not want to risk inflationary pressures lingering at the end of 2023 and be forced to choose between inflation and recession during the election process. Therefore, the Fed will not want any premature easing of financial conditions, and any attempt by the S&P 500 to rally will be met with renewed hawkish rhetoric from Fed officials. This situation is likely to continue until the Fed is satisfied with the decline in inflation, allowing it to consider the retreat that began a few months ago as virtually irreversible.
Quantitative tightening is the main risk going forward
Corporate management enters the new year with a cautious attitude and subdued capital expenditure intentions, which should help protect margins. As the main concern on markets is shifting from inflation to growth, investors are likely to focus increasingly on the earnings resilience of corporates going forward, including costs. As for the Q4 2022 earnings season, which has just started, analyst consensus expectations have recently been revised downwards, limiting the room for negative surprises.
We believe that the Fed’s effort to reduce its balance sheet (i.e. decrease the amount of liquidity in the economy via quantitative tightening) represents the main policy-mistake risk. This could, at some point, lead to market liquidity suddenly drying up, which lies at the basis of financial turmoil. Private-sector credit growth has helped to absorb the liquidity drainage for now, but it remains to be seen whether private credit demand stays elevated in the context of the normalisation of the US economy after the present reopening boom fades.
Meanwhile, the worst already seems to be behind us, with the latest data showing that global liquidity growth has bottomed out. Should nominal growth decelerate sustainably, as suggested by the latest inflation figures, liquidity could shift again from the real economy to the financial one, leading to further stabilisation in asset prices.