The US economy can cope with higher rates

CIO Daily Updates

by Chief Investment Office 28 Mar 2022 3 min read

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Thought of the day

US fixed income markets are pointing to rising fears of an economic slowdown or recession. The spread between the 2-year and 10-year US Treasury yield, a popular measure of expectations over economic growth, has fallen below 10 basis points, down from close to 90 basis points at the start of the year. In addition, 5-year yields are now higher than 30-year yields.

The move comes after further indications from the Federal Reserve that it is set on a swift series of rate rises this year, with the market priced for around 240 basis points over the course of 2022—which would be the fastest pace of tightening since 1994.

But despite these signals from bonds, we see grounds for optimism that the US economy can cope with higher rates.

The boost from post-COVID-19 reopening has further to go. COVID-19 case counts have fallen by more than 95% since the peak in mid-January. Mobility indicators, such as air travel and dining out, have recovered to pre-omicron levels, but are still below normal. We believe that there is still pent-up demand for the services that were most impacted by the pandemic, as well as for goods that have been in short supply, especially cars.

Household balance sheets remain strong, providing some cushion against the blow from higher borrowing costs and elevated inflation. The recent increase in consumer spending has been mostly driven by a falling savings rate rather than income growth. Although the savings rate is now in line with pre-pandemic norms, in our view there is still room for it to decline further.

Since the start of the pandemic, a lot of savings have been built up, and household wealth has surged due to rising equity markets and home prices. In addition, employment growth has remained robust, which should also help limit the downside to spending. Nonfarm payrolls were stronger than expected in February, rising by 678,000, and the unemployment rate fell to 3.8%.

The Federal Reserve retains the capacity to slow the pace of easing in response to an abrupt slowdown in growth. Although the pace of tightening penciled in by the Fed is the fastest seen in decades, we still believe the Fed’s goal is to normalize growth, rather than push it below trend or into recession. At present, the Fed is seeking to reassert its credentials for maintaining price stability. The focus could shift back to maximizing employment if rate rises or the war in Ukraine lead to an unexpectedly swift deceleration in growth.

Despite the considerable challenges, the Fed has an encouraging track record of tightening rates without causing recessions, including in 1965, 1984, and 1994. Other recessions, including the pandemic recession of 2020, were not the result of monetary tightening.

So, our base case is that the US economy can avoid a recession, lowering the threat of a sustained downtrend in stocks. As such, investors should brace for higher rates—including potentially adding exposure to value and financial stocks which tend to outperform as central bank policy tightens—without overreacting by exiting equity markets. We favor selected equity overweight and underweight positions, resulting in a neutral overall stance on the asset class.