Tuesday digest
Posted 20 September 2022
Overview: The Fed prepares for more tightening
As the period of mourning for Queen Elizabeth II ends, thoughts again turn to the war that continues to dominate our economy and markets, as it does throughout Western Europe and, to some degree Asia. Meanwhile, seemingly unaffected by the rest of the world, the US is blazing its own trail. This is predominantly because US energy security means it do not face the same input cost pressures. Nevertheless, inflation remains a problem for the US Federal Reserve (Fed) August consumer price data reflected a fall back in oil-related pressures, but tightness in the labour market continues to feed through. Therefore, the US is faced with a more structural inflation issue through looming wage-price-spiral dynamics than Europe.
It does look like the Fed loosened its grip on the US economy during the summer and will now have to tighten harder, after the fallback in inflation expectations data resulted in a degree of complacency. This week’s meeting of the Federal Reserve Open Markets Committee is expected to result in an interest rate hike of at least 0.75%, bringing the Fed Funds rate up to 3.25%. More importantly, analysts suggest the peak for US interest rates is now around 4.5%.
While the US economy is stronger than expected, one should not overstate it. The summer bounce has been relatively muted and August retail sales disappointed. Seasonally, consumer spending picks up through the last quarter, so the Fed will be keen to see if consumers have just delayed their purchases. It showed determination in the first part of the year, and we expect it will reassert itself this week. We would not be surprised by a 1% rate rise (rather than 0.75%) and think the market is already prepared for the bigger move.
US corporate credit shows few recessionary signs
Declining business confidence and the aggressive Fed has led to fears that debt repayments will become too great, sending companies into bankruptcy. The US yield curve (measuring the difference in payment terms between short and long-term government bonds) is still inverted, often a reliable recession indicator, with investors getting paid less to lend over ten years than over two. Credit spreads – the difference between corporate and government bond yields – have swung up and down over the last few weeks on the back of new inflation data. They widened after last week’s release showed inflation still running hot, prompting expectations of more Fed tightening than previously anticipated. But the Fed is only tightening because the economy is strong, consumers are spending, and employment is holding up well.
If a recession was looming, you would expect signs of stress in credit markets. While spreads have widened, acute stress has been contained so far. The fact that high yield credit in particular is doing so well speaks against imminent recession fears. Without a particularly sharp cost shock – like the one we are seeing now in Europe – economic strength should allow companies to deal with the rising cost of financing. As for recession indicators, we suspect they are down to global or technical factors, rather than a reflection of the US economy. The yield curve, for example, is skewed by the recent risk-off move from global investors – as many institutions are required to buy long-term US Treasury bonds.
None of this is to say that things could not turn for the worse. Sharp rate rises take a toll on businesses, and sectors like commercial real estate are particularly sensitive to interest rate moves. But it would likely take a significant weakening to create widespread default pressures. By most measures, equities remain expensive relative to credit – despite the market falls this year. You could read that pessimistically as a sign stocks need to sink further, but it could also signal that corporate credit is undervalued, as backed up by balance sheet resilience. Ultimately, the difference between the two scenarios is market sentiment, rather than underlying conditions. For better or worse, that sentiment will be a deciding factor in how corporate credit fares from here.
US midterms hang in the balance
The US midterm elections are less than two months away, and when America votes, the world watches. Capital markets are focused on ‘money’ rather than political impacts, and some commentators are warning that the midterms could be a source of volatility in the coming weeks. As recently as July, polling showed the Republican Party on track to regain control of the Senate, but the Democrats are now in better cheer with their fortunes improving over the summer. We see the same trend in the House of Representatives, albeit to a much lesser extent. A Republican victory looked a sure thing a few months ago, but the current expectation is that President Biden’s Democratic party will retain or even strengthen control of the Senate, while the Republicans are expected to snatch the House of Representatives away. Ceding the lower chamber would still frustrate Biden’s agenda and compound gridlock in Washington.
The state of the economy is generally a good guide to the ruling party’s fortunes. Consumer sentiment fell dramatically in the spring and summer, and the Democrats’ approval rating unsurprisingly declined with it. However, the swing may be partly due to the Supreme Court’s decision to overturn Roe v Wade, the landmark case which enabled nationwide access to abortion for the last 50 years. More worryingly for Republicans, it seems to have energised liberal voters. Unsurprisingly, Senate minority leader Mitch McConnell wants to steer the national conversation to inflation, the general economy and perceived “woke” liberal excesses.
In reality, these mid-terms are unlikely to change fiscal policy dramatically, particularly given the likelihood of a split and gridlocked legislature. For markets, foreign relations could be the most important battleground, especially the relationship with China. Whether markets would prefer Democrats or Republicans in Congress is hard to say and the recent swings do not appear to have been a big factor in asset market moves. Rather than the fiscal deficit, the trajectory for the current account deficit and the US Dollar may occupy investors’ minds.