“Why is it taking he Fed so long to slow the economy?” This is the question everyone is asking as we see conflicting forecasts and opinions on whether the Fed has finished hiking rates or if they still have more left to do. It is a very nuanced and challenging question to answer.
From a macro point of view with an economy the size of the US having a Gross Domestic Product of $23 trillion dollars, it would take years. In addition we have utilized (for at least the last 20 years) Monetary Policy to solve all problems (lowering interest rates whenever problems arose) and this will have a years long time lag to undo.
Therefore, the question of how long it will take for interest rates to normalize or for the economy to adjust to different interest rates has no definitive answer. Which is why so much “ink” gets spilled on this topic.
From Torsten Stok, chief economist at Apollo Global management:
“There are cyclical, structural, and policy reasons why the US economy continues to be so strong, see chart below. The Fed is pressing harder and harder on the brakes, and some indicators are starting to soften in the background….But we are not there yet. The economic data is slowing down and inflation is slowing down. But core inflation is still too high and sticky at 5%.
As a result, the Fed will continue to step on the brakes until they get what they want, namely slower growth and slower inflation. But the harder the Fed steps on the brakes, the higher the likelihood that we will see a sudden stop in bank lending, capital markets issuance, consumer spending, capex spending, or a correction in financial markets.” – Torsten Slok
Quite simply , Slok neatly sums up the problems with five observations:
High savings in the household sector, strong post covid demand for air travel, hotel, restaurants.
During the pandemic, high yield and investment grade corporates extended their maturities of their loans, making them less vulnerable to interest rates.
US households have 30 year fixed mortgages and are therefore less sensitive to Fed interest rate hikes. Higher interest rates are holding back supply of homes (sellers don’t want to sell, as they would get a new mortgage at twice the cost).
A growing share of capital expenditures spending is on intangibles; such as software, research and development, which generally are on the less sensitive side of interest rate hikes.
The IRA and CHIPS Act are creating a boom in energy transition and manufacturing.
June 30, 2023 marked the end of the 2Q/2023, and that means earnings season is here starting next week with the big banks announcing their financial results. What is interesting is the earnings recession is not new news. This has been widely predicted since the end of last year and the first 6 months of this year. One of the most popular predictions this year was that the earnings recession would cause stocks to fall. Quite simply, this has not happened. Factset has estimated the S&P 500 earnings have decreased by an estimated 6.8% year over year.
What do we see for the 2Q/2023 earnings? The two charts below show: First, most companies usually beat expectations, and Second, most important of all, stocks are forward looking. They have already discounted the earnings recession and are looking forward to the next 12 – 18 months, to rising earnings. Earnings drive stock markets. The charts below show 90 years of history earnings growth (Source).
While the history is not a guarantee of what will happen in the future, the trend patterns below are consistent. Earnings are the most important driver of stocks.
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Richard Mundinger, CFA