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In the past, I’ve often noted the challenges faced by economic forecasters in a world with too many variables where everyone has instant access to the same information. 2023 has been no different as a chorus of doom and gloom calls for the economy never materialized. These types of projections are frequently inaccurate because there are simply too many moving pieces, and while some make good soundbites for TV, they rarely provide a consistent edge to be used for investment decisions.
Knowing this, we built our investment process at Wavelength to manage forecasting risks, and instead of trying to make the best prediction, we assess the distribution of potential outcomes systematically and position our portfolio accordingly. With that being said, I have found that understanding the forces
that drive economic conditions and their links to financial markets can offer advantages to investors, particularly when policymakers are moving actively to meet the goals of their mandates.
As we’re now reaching the other side of a period impacted extensively by policy – during which the Fed raised interest rates by more than 5% in less than 18 months – I expect outright forecasts to remain challenged, but there are important features of how the economy works and connects to asset prices that will be critical to managing risks and seeking returns in the next phase of the cycle.
Holding strong...but for how long?
Since the beginning of the hiking cycle in March of 2022, the US economy has held up remarkably well in the face of rising rates. Growth over the period consistently exceeded expectations of forecasters surveyed by Bloomberg, and in the 3rd quarter – when many economists had predicted a recession to occur – real GDP increased at an annual rate of 4.9%, well above the long-term trend.
While it’s not surprising to see economists get their forecasts wrong, in this instance they had good reason to be surprised by the economy’s strength amidst widespread financial tightening. Higher rates naturally increase the cost of capital for businesses and consumers, which should correspondingly decrease their expenditures. This didn’t happen over the period for a couple of reasons unique to the pandemic and related stimulus, and while clear in hindsight, these were easy to miss following the economic shock of 2020.
Pandemic-driven policies created exceptional circumstances for both household and corporate balance sheets. On the household side of things, direct government transfers were made through stimulus checks, and with an initially limited set of places to spend, excess savings were accumulated then spent with a lag. Companies followed a similar path over the period, as record low rates drove a borrowing binge that caused cash levels on balance sheets to swell before more recently being spent on capital expenditures.
While this spend-down of abnormally high levels of cash from households and companies contributed significantly to growth over the past year, its support is fading fast as these dynamics were only temporary. After peaking at $2.1 trillion, the cumulative pandemic-era excess savings is estimated to have fallen to $350 billion as of October 2023, and following a boom in spending, cash on corporate balance sheets is also coming down. Without the government transfers or access to cheap capital seen coming out of the pandemic, the economy is now entering the next stage of the tightening cycle where the gravity of a higher cost of capital sets in.
Adjusting to the weight of rates
High cash levels from pandemic-driven policies may have helped stave off the impact of the Fed’s policy tightening thus far, but as cash runs out and debts are rolled, higher borrowing costs put incremental pressure on growth. Whether through mortgages, auto loans, or corporate debt service, the increase in rates is now flowing through parts of the economy that were previously insulated from the tightening cycle.
The higher debt service costs that result come as less of a shock than a banking crisis, for example, where access to credit is reduced in a rapid, often disorderly process. Instead, they create a steady drag on economic activity by discouraging spending and the large-scale capital expenditures we’d seen supporting the economy in the first stage of the tightening.
And while growth remained strong through the third quarter, early signs of this new dynamic are showing up in the behavior of both individuals and companies. Existing home sales are at a 13-year low, and while capital goods orders and shipments remain in positive territory, the capex intentions of businesses have dipped notably into negative territory.
It’s through these types of channels that higher rates are flowing through the financial system into the decisions of businesses and individuals. Additional weight is placed on economic activity when these entities adjust their spending and investment – and it’s without the support of outsized amounts of cash on balance sheets that these adjustments are now taking shape.
Preparing for what comes next
As discussed above, attempts at precisely timing the economic cycle and predicting where growth will be are rarely accurate and seldom provide a consistent edge for investment decisions. Look no further than the errors of professional forecasters over the past year to see evidence of this. With that being said, interest rates do have a fundamental impact on economic activity that can’t be ignored, particularly after their sharpest rise in decades. As is always the case, economies will adjust to a new set of conditions, and while this could go smoothly, there is also plenty of uncertainty from downward pressure on activity in the path ahead.
In this environment where the economy adjusts to incrementally higher debt service costs, a balanced exposure to yield-producing assets may offer a more consistent and relatively attractive investment approach. I think that a lot can happen in the coming months, and preparing portfolios for a wide range of potential outcomes will be critical as the reality of higher interest rates sets over the next phase of the cycle.
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