We have been weighing up when interest rates will actually start to come down and wanted to write about this and why it is important. The direction of interest rates has been the main focus of financial commentators and expectations have shifted significantly since the pandemic.
A short recap on what has happened in the last few years
“It’s the economy stupid”
How much money has been spent in the US?
The economy is a finely tuned machine but with some flexibility
Comment from the chief investment officer of LGT
QUICK RECAP
In 2020 governments were worried that the global economy would simply shut down (much like households had to) so governments threw money at the economy, businesses and at people. Interest rates went lower than ever and stimulus was given out with very little qualification.
By the end of 2020 economic activity rebounded and the roads went from unbelievably empty to really busy but the supply of goods was already curtailed as areas of the world that mostly manufacture what we consume weren’t producing and sending the same volume of goods as they once had – resulting in a significant shortage of goods/commodities and yet many people were willing to pay more to secure what was available.
This really was the start of the recent bout of inflation.
(Rent relief, bounce back loans, furlough payments (CJRS), help for hospitality, eat out to help out, self-employed income support scheme and more).
To exacerbate the situation job vacancies were low and businesses wanted to hold on to the people that they had coupled with large swathes of senior people deciding that they could afford to retire…they quite liked having time off and doing their own thing! So, we ended up with some wage inflation too (we realise that this didn’t extend to everyone).
So, throughout 2022 we saw interest rates rise significantly compared to where they were, as a countermeasure to inflation. This rapid increase in rates was great for savers (for the first time in nearly 15 years) but not so great for businesses needing capital and generally younger people with other types of debt (mortgages, credit cards, etc).
By the beginning of 2023, consensus was that the developed world was headed for a downturn. The impact of rising interest rates was working to bring down inflation and supply chains were slowly being restored and maybe we could expect a sharp fall in rates as we would soon get back to the inflation target of 2% (Bank of England).
SO, WHAT WENT WRONG?
The complex answer is lots of things but there isn’t the time to rehearse everything so let’s pick on something simple – US stimulus packages.
It looks like consensus didn’t really understand the impact of the US elections coming at the end of 2024 and the fact that re-election for a US president has always been hindered when an election was preceded by a recession or a downturn. (Alan Greenspan was famous for constantly trying to create lower rates during his 18-year tenure at the Federal Reserve – it didn’t always work out).
RECESSIONS HINDER PRESIDENTIAL POPULARITY
Presidents’ approval ratings suffer during recessions, but can rebound quickly during recoveries – if they are still in office.
It is conceivable that Joe Biden’s team were clearly able to see that having a downturn before an election is a form of political suicide (a downturn was what markets were predicting in 2023). Of course, all Presidents want their country to thrive… but they can’t help noticing that, “It’s the economy stupid” (quote from James Carville in 1992). Interestingly, the significant spending may have a negative effect on his campaign as some voters blame him for higher inflation for longer.
HOW MUCH STIMULUS HAS THERE BEEN?
HOW THE US SPENT $5 TRILLION
SPENDING AS A PERCENTAGE OF GDP
Marshall Plan was 5% of 1947 GDP.
Covid response was 20% of 2023 US GDP.
WHERE ARE WE NOW & WHAT HAPPENS NEXT?
In principle a policy of rising and higher interest rates is clearly designed to counter inflation and it seems to be working. If you pump money into the economy it can and should boost the economy or fuel inflation, if you take liquidity out of the economy it should have the reverse effect and so cool inflation or slow the economy.
One question remains in my mind, were US policy makers clever or just lucky?
The US economy has powered ahead and seems to have struck a balance between achieving growth and yet holding back inflation (please note that the electorate may judge this differently). Higher rates have stayed high for longer than anyone in the US initially thought but the stimulus packages seem not to have overheated the economy but have kept prices up in the process.
There are many reasons why this is so but one important factor is that they do have more control over energy prices so didn’t have to contend with the Fuel Crisis in the way that Europe did.
GLOBAL CRUDE OIL & CONDENSATE PRODUCTION IN 2023 BY SELECT COUNTRIES
Million barrels per day
CONSENSUS VIEWPOINT
Some central banks have already started to lower their rates. Unusually the US seems to be the last in the line when it comes to when they will lower their rates – normally they are the first to react.
The Bank of England now expects rates to fall this summer although they have been held at the latest MPC meeting. They also expect to see inflation hit just 1.9% within two years and 1.6% within three years.
THE ECONOMY IS A FINELY TUNED MACHINE BUT WITH SOME FLEXIBILITY
It really does matter where rates are and how high inflation is. Very low interest rates (during the pandemic) can encourage people to spend too much and spend unwisely, as borrowing is so cheap. High inflation or high interest rates makes it too costly to borrow so people will go without and choose how to spend more carefully.
High inflation is also very destructive and would cause a real drop in the value of things that ordinarily do have value, homes, investments, businesses, etc. High rates makes it harder for the economy to grow as businesses need to borrow money to grow, people need to borrow money to own a home and if the population can’t spend then a knock on effect can be that people will start to lose their jobs as there is less money flowing through the economy, so it really is a fine balance to get right.
RECENT COMMENT FROM OUR INVESTMENT PARTNERS – LGT
The CIO from LGT has recently commented: “With inflation trending back towards target and economic indicators seeming supportive the path to interest rate cuts has cleared.
With earnings season predominantly finished we can assess the corporate environment. Despite noise regarding economic cooling it appears that we are indeed past trough earnings for this cycle. Over 75% of S&P 500 companies have reported positive EPS surprises and there appears to be momentum in earnings growth, which is welcome after nine quarters of negative EPS growth.
Expectations are that this growth will continue, with both companies and analysts increasing their estimates for EPS growth over the full year. This is also broad-based, with seven of the eleven sectors in the index recording positive growth. Whilst the discussion around macroeconomic momentum continues, weakness does not yet appear to have manifested in the economy”.
Thank you for taking the time to read my thoughts and viewpoint – we believe that at the end of this year we will look back and see the returns and events as positive overall and investments will reflect a more stable outlook.
