Higher-for-longer interest rates to slow economic growth and drive the US economy into a recession

• Markets and the Fed disagree on the path of interest rates. While the market still expects rate cuts to begin as early as the second half of this year, the Fed, on the other hand, plans to keep rates higher for longer.  

• We believe that the Fed is right in this case. The continuing tightness in the labour market and persistently high inflation will make it very difficult for the Fed to cut interest rates this year. 

• A US recession seems unavoidable this year. Our base case is for a mild recession to occur in the second half of 2023, largely caused by aggressive Fed policy. 

• We maintain a 2.5 Stars “Neutral” rating for US equities. Investors who are still keen to remain in the US equity space may want to consider adopting a quality/value tilt instead. Alternatively, they may also consider short duration bonds for their attractive yields. 

Early last year, the US Federal Reserve embarked on what is now known as the most aggressive rate tightening cycle since 1981, sending rates up by 450 bps in a span of 11 months (March 2022 – February 2023). This is roughly equivalent to a rate of change of 40 bps each month (Table 1).

After more than a decade of low interest rates, monetary policy saw a dramatic shift as the Fed sought to avoid a repeat of the 1970s wage-price spiral, which sent the US economy into one of the deepest recessions since the Great Depression. But with interest rates already nearing the peak levels seen before the Global Financial Crisis (GFC) and leading economic indicators showing a sustained decline, just how much higher can rates go? 

Table 1: The current rate-tightening cycle has been the most aggressive in recent times

Figure 1: The US fed funds rate is quickly approaching levels that were last seen during the GFC 

Markets and the Fed disagree on the path of interest rates 

Over the course of the year, most major investment banks have made upward revisions to their interest rate forecast as the Fed continued to hike rates aggressively. As of 23 February 2023, most estimates put the terminal fed funds rate to be somewhere between 5.1% and 5.5%. 

The Fed’s own forecast, (found in December’s edition of the Summary of Economic Projections) showed that committee members expect interest rates to peak between 5.1% and 5.4%, where it will stay throughout the year. This is slightly higher compared to September’s forecast of 4.4% - 4.9%. 

Working backwards, we can see that the US is approaching the tail end of the hiking cycle with approximately another 50 - 75 bps of rate hikes to go. The end of the rate hiking cycle is also evidenced by the Fed shifting to a smaller 25 bps rate hike in February, after delivering four consecutive “jumbo” 75 bps rate hikes last year. 

Similar to the Fed, markets are also expecting interest rates to peak at around 5.3%, according to the latest fed funds futures pricing data. Where it differs is how long will interest rates stay at their peak for. Unlike the Fed, which expects interest rates to remain above 5% throughout 2023, markets are anticipating the first rate cut to arrive as soon as September (Figure 2).

Figure 2: Markets are expecting rate cuts to start as soon as September 2023 

Between the two camps, we think that the Fed is probably right in this case. We think that interest rates are likely to stay in the range of 5% - 5.25% throughout this year. Given the current economic climate, the probability of rate cuts happening this early are very slim. Here are a few reasons why. 

Firstly, even though inflation has subsided, it still remains well above the Fed’s target. January saw consumer prices rising by 6.4% year-on-year, above estimates of a 6.2% increase. On a month-on-month basis, prices reaccelerated by 0.5% after a gain of 0.1% in December, proving that inflation has been hard to vanquish. 

Minutes from the FOMC’s meeting in February also showed that the Fed remains laser focused on returning inflation back to its 2% target. It said that despite some relief in the recent months, inflation remains unacceptably high. Several committee members saw the case for returning to larger rate hikes in the future if inflation remains elevated. They have also cautioned against prematurely loosening monetary policy.  

Next, the labour market is still too tight for the Fed’s comfort. January saw jobs growth rising by a massive 517,000, nearly triple the median consensus forecast of 185,000 jobs, while the unemployment rate fell 3.4%, the lowest in five decades (Figure 3). 

America’s tight labour market continues to be a pain point for the Fed, which has long said that in order for inflation to fall, unemployment must rise. With that said, we believe that the continuing tightness in the labour market and persistently high inflation will make it very hard for the Fed to cut rates this year. With interest rates likely to stay higher for longer, the risk of a US recession has also become more pronounced. 

Figure 3: The current tight labour market will make it harder for the Fed to cut rates

A US recession will likely be unavoidable, but mild

Looking ahead, we see a challenging macroeconomic environment for the US. Our base case is for a mild recession to occur in the second half of 2023, largely caused by aggressive Fed policy. The track record is undeniable. Out of the seven rate tightening cycles since 1980, six of them have ended in a recession. Given how much more aggressive the current rate tightening cycle is compared to the ones before, we think that a recession is inevitable. 

While the US economy grew at a faster-than-expected pace in the last quarter of 2022 (2.9% vs. estimates of 2.6%), it was largely due to a build-up in inventories and a narrowing of the trade deficit, both of which are often volatile categories and are not sustainable sources of growth. Consumer spending, the bedrock of the US economy, weakened from the previous quarter but still remained in positive territory. With the impact of higher interest rates yet to be felt fully, the drag on economic activity will intensify in the quarters ahead.

As a matter of fact, leading economic indicators, metrics used to forecast changes in the economy before they actually happen, have been on a downtrend, suggesting that the US economy is likely to slow even further in the months ahead. In January 2023, the US Leading Economic Index (LEI) fell again by -5.6% year-on-year, after a falling by -6.0% in December 2022. A reading below the threshold of -4.0% signals a recession (Figure 4). 

Figure 4: Leading indicators are already pointing towards a slowdown in the economy

Turning our attention back to the labour market. According to the Fed’s latest projections, unemployment in the US is expected to rise as high as 4.7% in 2023, more than a full percentage point higher from its current level. In the history of the US, the unemployment rate has never risen by 0.5% above the preceding 12-month low without triggering a recession. This means that if the Fed’s forecast were to materialise, it is only a matter of time before a recession occurs.

Figure 5: The Fed’s forecast of the unemployment rate implicitly suggests that it too expects a recession to occur 

As depressing as the outlook might be, investors still have reasons to be optimistic. While a recession may be difficult to avoid, it is likely to be mild barring any unforeseen shocks. Rising borrowing costs are bound to push up default rates. However, consumers and businesses have much healthier balance sheets this time round compared to previous recessions, such as in 2008 and 2001 (Figure 6).

Businesses, in particular, have taken advantage of the low interest rate environment during the pandemic to refinance their existing debt at lower rates and for longer durations. This is critical as it means that there is less need for them to revisit credit markets for funding over the next few years. Meanwhile, consumers are also in a better position to tide through this higher-for-longer interest rate environment as their total liabilities and debt service payments as a percentage of disposable income are both significantly lower than the previous recession. 

Figure 6: Consumer and corporate balance sheets are much stronger today than before 

(Related Article: A global recession is likely unavoidable in 2023. Here’s how you can prepare for it.)

Key investment risks 

Prolonged/deep recession: Even though a shallow recession seems to be the more likely outcome, the possibility of a prolonged and deep recession is not out of the question. This could happen in the event that inflation remains a lot more persistent than expect, forcing the Fed to raise rates even higher than previously projected, thus increasing the risk of overtightening. If this occurs, the share prices of US equities will likely take an even greater hit. 

Geopolitical risks: From the Russia-Ukraine war to rising tensions between US and China, 2022 has been a year filled with geopolitical risks. If these issues were to escalate or if new crises emerge, equity market volatility and the geopolitical risk premium that investors are pricing in are likely to rise, leading to lower returns for equities.

Maintain 2.5 Stars “Neutral” as recession risks mount, limited upside

With a challenging outlook ahead, we continue to remain neutral on US equities. US equities have also rallied by a fair bit since 3Q22, further diminishing any available upside potential. Based on our estimates, the S&P 500 Index is currently trading at 16.6X 2024E EPS, compared to our fair PE multiple of 18X. This translates to an upside potential of less than 10% based on the last traded price of 3991 as of 22 Feb 2023. 

Table 2: US equities have limited upside thanks to their lofty valuations 

And with a mild recession expected to occur by the end of the year, US equities, especially growth stocks, will continue to be challenged. History has shown that tighter financial conditions tend to drive a compression in equity valuations, especially for the more richly valued areas of the market (e.g. growth stocks), as these tend to have the highest equity duration. 

Instead of growth, we recommend investors who are still keen to stay invested in the US market to consider adopting a quality/value tilt. The quality factor has been time-tested to outperform growth, or even broader market during downturns as they tend to experience smaller EPS declines relative to other companies. High-quality companies have also proven to have a lower maximum drawdown even during recessions, an attribute that is desirable given the current market environment.

Value stocks on the other hand are still trading at attractive valuations relative to history, growth and the broader market, giving it room to re-rate higher. The value composition also provides investors with exposure to a good blend of cheap, defensive companies as well as to potential sectoral winners such as those supported by thematic shifts such as high-for-longer rates, energy shortages, and de-globalisation.

Investors who are keen to add exposure to US quality/value companies can do so via the JPMorgan US Quality Factor ETF (NYSE:JQUA) and the JPMorgan Funds - US Value A (acc) USD.

(Related Article: Quality investing: The answer to outperforming growth in a recession (and even in the long term)

(Related Article: Rise of the underdog. The comeback of US Value stocks)

Alternatively, given that bond yields (short duration in particular) are now significantly higher than where they were at the beginning of the year, fixed income has never looked this attractive relative to equities over the past decade or so. As such, investors can also consider an allocation to SGD-centric short duration bond funds to enjoy juicer returns without having to take on greater duration risk.

Table 3: Recommended funds for short duration bonds 

(Related Article: DIY Cash Management: Park your cash in these funds to attain higher yields)

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.