If it is impossible to know where the world is going, it is at least advisable to try to have a clear idea where it is. To understand the state of the global economy, therefore, it is useful to look at it through the lenses of the most critical factors: growth and interest rates.
The one constant underpinning financial markets since the beginning of the 1980s has been the inexorable decline in interest rates. The US 10-year bond yield has gone from 15.8% in 1981 to a pandemic-era all-time low of 0.67% in March 2020. Since then it has risen sharply, reaching a recent high of 4.2% in November.
This may sound of little consequence, but it is fundamental to understanding the global economy and financial markets. Lower interest rates have three critical effects.
First, they encourage economic expansion through a mix of cheaper debt, resulting in more borrowing and thus higher levels of consumption, fixed capital investment and job creation. Ever lower rates have effectively been a four-decade free lunch for the global economy.
Second, the US 10-year bond yield acts as the benchmark for the discount rates used to price all securities. The lower the interest rate, the higher the valuation investors will place on a future income stream.
As rates have ground down year after year for four decades, the valuations of all securities – equities and bonds alike – have soared. The S&P 500 went from a low of 102 in August 1982 to 4,796 at the beginning of 2022, an annual compound growth rate of 10.3% a year.
Several “real economy” factors have been behind this. The fruits of higher productivity, technological innovation and increasing trade from globalisation have meant greater corporate profitability and higher valuations. Arguably, however, this relentless rise in asset prices has been simply a repricing of future profits.
The third effect is that lower returns from “risk-free” investing, such as lending to the US government for 10 years, force investors into riskier assets to ensure they attain desired investment returns. This created a new investment mentality.
Investing went from being about mitigating risks to being about how to take advantage of any apparent risk and return mispricing arbitrage. Suddenly there was a market for everything, as investors created demand for more and more exotic asset classes in a voracious hunt for returns.
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But overly easy fiscal and monetary policy during the pandemic, combined with supply-side blockages and soaring energy prices following the invasion of Ukraine, has resulted in the highest inflation since the 1970s. By November 2021 it was clear.
Soaring prices were not a transitory phenomenon, as had been assumed previously. The hands of central bankers were forced; rates needed to rise, and fast.
Ultimately, the story of the global economy in 2022 is largely one of rates rising materially for the first time in four decades. Everything else – the 15.6% fall in the S&P 500, 28% collapse in the Nasdaq, disintegration of the crypto market, humbling of Big Tech – should be seen through this lens. The interest rate is omnipotent.
Economic growth is the second key variable, which can either be seen through nominal GDP expansion or corporate earnings. Global nominal GDP has risen by 3.2% a year since 1980. This is impressive; in that period the world has witnessed the single biggest improvement in living standards and reduction in extreme poverty in history.
It remains to be seen, however, where growth will go from here. Much of the low-hanging fruit has been plucked. Globalisation has stalled, if not been in reverse. Skyrocketing energy prices are sapping savings and gross fixed-capital formation, and are likely driving the eurozone and the UK into recession in early 2023.
Inverted yield curves suggest a US recession in late 2023 is a distinct possibility, if not a certainty. Here the discussion has to return to the impact of higher yields.
It is hard to imagine how economies such as the eurozone, the UK and the US can operate with higher interest rates. Corporates, consumers and governments have all become dependent on being able to borrow effectively for free. The single most critical question investors need to consider thus is what impact higher rates will have on the broader economy. More specifically, will they push it into recession?
On this point, the most critical factor is employment in the US and Europe. Though a lagging indicator, higher unemployment means a weaker consumer base, which further dents corporate earnings and growth.
With employment at all-time highs in the US, UK and Europe and labour markets unprecedentedly tight, unemployment can only go one way: up.
A lower aggregate demand from weaker labour markets and the distinct possibility of a recession should worry investors. But equity investors are seemingly deeply insouciant about all these risks.
Equity markets in the US have had their best final quarter since 1999. The S&P 500 is up 12.1% in the past three months, pricing in what has been termed a “soft landing”.
Essentially, this is that the Fed hikes rates enough to moderate inflation, but that low unemployment and resilient consumer demand ensure the global economy avoids a complete nosedive. Unemployment would go up enough to bring wages down, precluding a wage and price spiral, but it does not rise to levels that wreck the demand side of the economy.
Valuations are almost delusional in their optimism and conviction of this outcome. Yearly profit growth of 5.2% is the consensus expectation for the S&P 500, which off the strong base of 2022 seems extremely elevated and entirely contingent on the US avoiding a recession.
Assumptions of net profit margins, derived from revenue and profit forecasts, inspire doubts too. Analysts expect them to nudge up from 12% to 12.3% in 2023, making them the second highest since 2008, immediately prior to the financial crisis. Once again, like employment, when things are at their best ever, it can only be that they are about to get worse.
This implicit assumption of a soft landing being the story of 2023 could turn out to be very expensive for investors. Reminiscent of the “Goldilocks” economy so popular among analysts in the pre-financial crisis market of 2007, such supposed “perfect” equilibriums have never proved to last for long.
Much of what happens on this question of whether there is a Fed-induced recession or not will come down to inflation. Will it come down rapidly or remain stubbornly elevated through 2023?
Clearly, the US CPI print last week was good news. It showed a broad-based deceleration in inflation with month-on-month CPI sinking below 0.2%, or 2.4% annually. The market immediately jumped on this as excellent news and further evidence of an impending Fed “pivot” from inflation-targeting hikes to employment-stimulating interest rate cuts, rising 2.67%.
However, zooming out, gentler inflation makes a recession only slightly less likely. The Fed is rightly afraid of letting up too early and inflation rebounding. It will push on with rate rises, perhaps more slowly.
But the greatest risk to the global economy and markets – and perhaps the critical moment of 2023 – will be when inflation is falling but still elevated and outside of the targeted range. At this point, how the central bank balances its double mandate – price stability and full employment – will be key. What will it prioritise at the expense of the other: growth or getting inflation down?
The market at this point is clearly assuming it will be the former. Based on what we have seen from Jay Powell over the past year, I would assume the latter.
The data suggests we are approaching that point faster and in more robust shape than expected. But it is unlikely we will escape it altogether. Interest rates operate with a frustrating lag; actions made by a central bank today are only seen in the economy in several months’ time.
It remains likely that interest rates have already been hiked enough to push the global economy into a recession, if only in the latter half of 2023. It is unclear that inflation can be moderated back to within the target range in the US, UK and eurozone without a substantial drop in aggregate demand, higher unemployment and a contraction in economic activity.
The new year may well portend even tougher economic times ahead. You have been warned. DM168
This story first appeared in our weekly Daily Maverick 168 newspaper, which is available countrywide for R25.
