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The Federal Reserve must not over tighten and make any recession worse.

  • Wednesday, May 24, 2023

Jerome H. Powell, governor of the Federal Reserve BoardAt the beginning of 2023 there was a consensus of an early recession in Europe and with the USA not far behind. Economists were concerned that a continuation of China’s zero Covid policy would lead to another poor growth year. As it is, inflation has peaked and is falling, recession has been avoided and China has ended its zero Covid policy. China’s opening should boost world growth and improve supply chains as well as push down inflation.

The swift recovery of equity markets in January came as a bit of a surprise to investment professionals. The strong equity rally came despite economic indicators predicting economic contraction. Central Banks continued to raise interest rates and the level of consumer excess savings having been run down in the face of a cost-of-living hike which will inevitably impact consumer confidence, household spending and corporate earnings. So far that has not been the case but is now expected.

The failings of both Silicon Valley Bank in the US and Credit Suisse in Europe has caused concern about a looming banking crisis. There were unique factors that put pressure on these banks that are not representative of the broader banking system.

SVB was a tech lender with a very concentrated corporate deposit base mostly above the Federal Deposit Insurance Corporation guarantee levels of US$250,000 per deposit. Raising rates meant that SVB was burning through its cash to cover interest payments that were not offset by a traditional mortgage book.

Credit Suisse was in trouble long before the recent banking concerns. Its share price had fallen 80% from its peak as it was incapable of making money. Credit Suisse has struggled for some time and was known as the weakest bank in Europe.

The outcome of these banking fears is that tighter credit conditions will develop as banking becomes less willing to lend and will look after securing their balance sheets. Tighter lending standards does slow growth but at this stage it is not clear what will develop. We are facing uncertainty in the banking sector but not expecting a new major banking crisis. The general health of the global economy is far stronger than it was in 2008.

The impact of tightening of monetary conditions will be monitored by policy makers and it is likely to result in a pause in interest rate rises in order to see if inflation continues to fall without any further rate hikes. A recession in the US in late 2023 is more likely, so the Federal Reserve will be mindful of not over tightening and making any recession worse than is needed.

While the Fed raised their interest rates by 0.25% on 3rd May, the Bank of England’s (BoE) Monetary Policy Committee met on 11th May and raised rates by 0.25% to 4.5%. With UK inflation at 8.7% continues to be a problem. Higher interest rates will hit mortgage payers and business costs. The UK growth forecasts are relatively weak but positive so an early pause in interest rate rises is expected.

The bond market is returning to be the diversifier to equity it always used to be, after a period of combined losses over the past 12 months. With interest rates peaking and bond yields stabilising bonds can be the diversifier they need to be. Any threat of recession will boost the bond market attraction particularly government bonds and investment grade credit.

The general outlook is better for high quality value stock. Markets have not yet priced in recession as PE ratios are back to be above average in the US but remain good value in the UK, Europe, China, and Emerging Markets. European and value style stock is expected to outperform US and growth style stock this year.

China is now seeing consumer confidence return but this is not being reflected at all in stock market values. The large pent-up savings from months of zero Covid lockdown will be spent as China opens. The lower stock values of Chinese equities and the accelerated consumer spending should make China an attractive investment region but this is not coming through yet.

The opening of China, the easing of Europe’s energy crisis and the warmer weather in the USA and Europe have all boosted global growth. But despite these improvements, mild recession in the developed economies later this year is now likely. Europe could potentially enter recession this summer followed by the US in the Autumn. China with no inflation problems is expected to expand.

Inflation remains a problem particularly in the UK at 8.7% year on year to the end of April (falling from 10.1% in March) and in the Eurozone with inflation at 7%. Because of this, central banks have not yet finished their tightening policy of raising interest rates. It is common to discover the impact of interest rate rises some 12 months after the changes were made. It is this quarter that the effects of rapid rate hikes are being felt. This has been expressed as pressure in the banking sector which has led to several banking failures and additionally, excess savings accumulated by households is declining on the back of the cost-of-living increases. This will impact consumer confidence that has so far been surprisingly robust.

Fortunately, inflation is generally now falling across the major developed countries and is expected to continue to fall throughout the rest of the year. Inflation in goods that suffered acute shortages during the pandemic have now all but ended in the US and not far behind in Europe. Food inflation remains a big issue but energy costs are materially reducing. UK Natural Gas prices have fallen by 50% from £165 to £83 per trm so far this year. The fall in gas prices in Europe particularly has been a boost both to sentiment and energy security and strong inventories will ensure lower gas prices this year and next.

While inflation is expected to fall, it may not fall back as quickly as hoped due to the tightness in the employment market. The US labour market is strong with 3.4% unemployment while the UK has 3.8% unemployment. For these reasons wage growth, which is inflationary, will remain strong for some time.

The actions of all major central banks since the failure of SVB and Credit Suisse has been to continue to raise interest rates. Despite the impact on the weaker banks of rapid rate rises, the central banks remain focused on bringing down inflation. With all G20 countries with inflation over 2% target, other than China at 0.7%, it is hard to see rate cuts happening soon unless there is a widespread failing in banks or a deep recession. Neither look likely at this moment but the stress on banks is real.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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