By Avi Deutsch
July 14, 2023 – Jerome Powell’s (“JP”) biography should make for a fascinating read. The Fed chairman, who was nominated by Donald Trump and is the first non-economist to serve since 1981 has become one of the most powerful figures in today’s economy. Though far from perfect, JP has shown himself to be a steady hand at the tiller through political, social, and global turmoil.
Undoubtfully to his regret, JP’s legacy will forever be tainted by his prediction that the inflation that started in late 2020 was ‘transitory.’ Though the Fed was far from alone in this false belief, its failure to act until early 2022 represents a missed opportunity with far-reaching economic consequences. There were of course mitigating circumstances, chief among them the fallout from Covid-19 and the Russian invasion of Ukraine. But to paraphrase John Wooden, JP’s supporters don’t need excuses, and his foes won’t believe them anyway.
Despite, or perhaps because of its late awakening to the inflation predicament, when the Fed did start raising rates, it did so at the fastest rate in the past 40 years, hiking rates by 5% in just 13 months. Many predicted that such a rapid increase would plunge the US economy into a recession. These fears peaked in March when SVB and Signature Bank fell victim to rising rates and poor management and oversight. And yet here we are, over a year into the rate hikes, and the unemployment rate stands at 3.7% and the Atlanta Fed’s GDPNow model estimates real growth in the second quarter of 2023 at 2.1% annually.1 The predicted recession remains still a prediction.
To be sure, recession clouds still loom over the horizon and many economists and investors now predict a recession in 2024. And yet, every day the recession is staved off is a win for JP. By nature of business cycles, we are always ‘between recessions’, and the longer the interval between economic contractions, the more time the economy has to grow and blunt the effect of the next downturn. At least for this brief moment in time, JP has piloted the US economy from a peak of 9.1% inflation to the more comfortable 4% without triggering a recession, an achievement that will undoubtfully be shadowed by past mistakes and future events.
None of this means that JP can declare victory. May’s inflation reading showed prices increasing at 4% annually, double the Fed’s target of 2%. With the continued strength in the labor market, the Fed will likely need to continue raising rates and investors are now pricing one or two additional rate hikes this year.
If the US seems to be, at least temporarily, on a stable economic footing, global events continue to be a source of concern. Rising tensions with China threaten not only economic growth and progress of the energy transition, but also carry the very real risk of a violent escalation, likely against Taiwan. The disappointing performance of the Chinese economy after the much-anticipated Covid reopening is a double edge sword for China hawks. A weaker China could quickly become a more desperate China, and Russia’s experience in Ukraine may not be enough to dissuade the Chinese leadership from choosing aggression as the next phase of their pre-ordained path towards global leadership.
Russia, meanwhile, continues tumbling down the global leadership ladder. A failed coup by the Wagner Group’s Yevgeny Prigozhin quickened heartbeats around the globe with a mixture of hope for the crumbling of Putin’s regime, and the abject fear of the world’s largest nuclear arsenal falling into the hands of vicious mercenary, or worse. If the coup itself marked a perceived chink in Putin’s armor, its failure could lead to a purge that would leave Putin firmly in power, if more isolated than ever. Though the European economies have fared far better than expected since the beginning of the Ukraine war, with Russia’s impact on energy markets blunted by a mild European winter and global effort, a disintegration of the Russian state would pose a serious threat to Europe and the rest of the world.
The Markets
Perhaps the most surprising financial development in the first half of 2023 was the resilience of the equity markets, and especially of tech stocks. The MSCI All Country World Index rose 14.3% in the first half of the year, and the tech heavy NASDAQ 100 was up 39.3%. The S&P 500 is now trading at 19x estimated earnings, a premium over the 20-year average of 15x. The stock market’s performance remains heavily skewed towards a handful of mega-cap tech companies.
Beyond the strong economic performance, a key driver of these returns appears to be the growing use of AI, and specifically of large language models (LLMs), in everyday tasks. There is no doubt the use of AI will continue to grow rapidly, making some jobs easier, and some entirely dispensable. Still, one can’t help but wonder if the hype exceeds reality, as it has many times before, from tulips to cryptocurrencies. With that in mind, we continue to look for ways to capture the AI opportunity in both public and private markets.
The bond markets did not fare as well in the first half of the year, with the Global Agg returning just 1.43%. This is a result of a clear shift in expectations between April and today. In the wake of SVB’s collapse, investors predicted that the Fed would need to start cutting rates before the end of the year. Three months later, the fallout from the collapse appears to be minimal, with the economy chugging along at a pace that will require additional rate increases this year. With these expectations, the yield curve remains deeply inverted, with short term rates higher than longer term rates.
The Outlook
The Fed’s decision to hold interest rates steady in June can be seen as a chance to let the economy and the data catch up with the interest rate environment. As the data has come in showing the labor market remains red-hot, interest rate hikes later this year appear increasingly likely.
As at the beginning of this tightening cycle, two scenarios could follow. The first is a continuation of the soft landing we’ve been experiencing, but with the economy finally slowing down or even hitting a mild recession. This is the best-case scenario. The second and more troublesome scenario is that rising rates trigger another financial collapse a la SVB, but this time the damage is not as easily contained and the economy spirals into a deeper recession. Rising rates come with a variety of risks to the economy and financial markets. Some, like commercial real estate and corporate debt, are being widely discussed. But the ones we should worry us are those we don’t know yet to look for. Just recall how earlier this year, few, if any, thought bank balance sheets would be the first victim of rising rates until SVB’s implosion.
With this uncertainty ahead, the importance of asset allocation and the matching of risk to investors’ needs and goals remains as important as ever.
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