Two reasons the consensus view may be wrong

We recognise that a soft-landing of the US economy has now become the consensus view among investors. However, we do not believe that the US Federal Reserve (“Fed”) will ease monetary policy to the extent that many investors are expecting. As a result, we still believe a recession is the most probable outcome for the US economy over the next 12 months.

So why are investors expecting more rate cuts in 2024 than the Fed has signalled they will execute? This is simply because the market expects that inflation will come in lower than what the Fed has forecast. The markets’ hope is that once the Fed’s FOMC members realise their error, they will begin cutting rates by more than what they had initially projected.

We believe this is unlikely for two reasons.

First, investors are assuming inflation will fully return to target this year because core inflation (excluding housing) is already at 2%. While core inflation may have pleasingly receded to the Fed’s target, housing inflation has not declined as swiftly. To be clear, forward-looking measures of housing inflation are indeed suggesting that prices will come down, but the uncertainty pertains to the speed at which that will occur. The issue is that while multi-family housing supply is increasing, relieving upward pressure on rentals, single-family homes are actually rising in price and thus increasing rentals. This does not mean that rental inflation must start rising again, but it does highlight that straight line disinflation is not guaranteed.

The market’s inflation expectations are so bullish that we believe many investors are in for a hawkish shock if inflation simply follows the Fed’s forecast. Assuming the Fed is correct, it is very unlikely that the Fed will cut more than three times this year, disappointing investors. The only scenario in which the Fed would cut rates more than three times would be if unemployment began rising rapidly, in which case it is safe to say the hope of a soft landing would also be dashed.

The second problem is that investors are pricing in that rates will eventually decline to a neutral rate of around 2.5%. In our view this level is unlikely. Prior to the pandemic, when the neutral rate was estimated, inflation expectations were well below where they are now. In this new economic environment, where higher inflation expectations prevail, the neutral level of interest rates will likely also be higher at around 3.7% as indicated by the dotted line in Figure 1.

Figure 1 – In contrast to Fed guidance, investors are expecting neutral monetary policy in 2024

Do not just rely on the unemployment rate

Many investors are looking for a trigger to usher in the onset of a recession. We argue that no trigger is required. Rather the consistent deterioration of demand for labour, a trend currently underway, is all that is needed.

While unemployment is a valuable metric in measuring how strong the labour market is, it is, however, a lagging indicator. Focussing on unemployment alone is especially problematic in a full employment economy such as the US at present. Thus, to really see the underlying trends in the labour market, one should look at alternative, more forward-looking measures.

For example, Figure 2A, which depicts the trend of slowing wage growth and lower job openings, signals that the demand for labour is cooling. Another interesting indicator is the job hiring rate. Firms typically stop hiring well before they start firing employees. Thus, if you want to pre-empt the extent of firing, looking at the decline in the rate of hiring can be effective. Figure 2B illustrates how the JOLTS hiring rate has now fallen below pre-pandemic levels.

Figure 2A & 2B – Alternative measures of a cooling labour market

Another useful measure of the job market is the quits rate. When the economy is doing well, employees readily quit their job with little concern regarding their ability to find another, better role. However, as Figure 3 depicts, the quits rate has now fallen below pre-pandemic levels, indicating that the job market has now cooled even below what was considered “normal” levels and could be heading towards recessionary territory.

Figure 3 – If new jobs become harder to find, fewer employees resign

If the Fed cuts rates proactively to prevent a recession, one could see the above metrics improve and labour demand reaccelerate. Of course, a reacceleration of the economy could fuel a second wave of inflation. Given how badly most central banks were burned by the sharp rise in inflation in 2021, we believe it is unlikely that the Fed would do this, instead opting to maintain a cautious monetary policy stance. The Fed would likely prefer to cut rates aggressively only once clear signs of an impending recession have emerged.

Investment takeaways

In the short term, the Fed’s December policy shift will remain bullish for equity markets, at least until something acts to counter the optimistic soft-landing narrative. The current “risk on” sentiment will likely continue until the Fed verbally reins in the markets’ overly aggressive rate cut expectations or demonstrates that the expected level of cuts will not materialise. Furthermore, the “risk on” trade could also be dampened by either a reacceleration in inflation or the materialisation of obvious recessionary events in the labour market.

In summary, we believe that the US economy remains on a recessionary path as long as monetary policy remains tight. Even in a “no landing” outcome where inflation returns to the Fed’s target and unemployment remains too low, we still would not be optimistic as this would likely lead to a reacceleration of both growth and inflation, forcing the Fed to hike rates further. For the time being, some gains in risk assets are available, but downside risks are looming.

If you interested in finding out more about how cognisance of the macroeconomic backdrop helps our clients invest, connect with Integrity Asset Management and let us help you navigate your investing journey.

For more information on this synopsis or to discuss solutions provided by Integrity Asset Management, please contact us at:

Tel: (021) 671 2112
Cell: 072 513 2684 / 084 601 1025
E-mail: nic@integrityam.co.za / herman@integrityam.co.za

Source: Bloomberg, 31 January 2024