By Dr. Alan Greenspan, Senior Economic Advisor
As investors prepare to close the books on 2022, the debate that has loomed large throughout much of the year, and will continue into the next, is whether or not the Federal Reserve can engineer a soft landing. After a journey that has spanned six consecutive rate increases over nine months, for a total increase of 3.75 percentage points in the federal funds target rate, the Fed is nearly ready to pull back on the yoke and leave interest rates on cruise control. As the runway approaches, the answer of whether a soft landing is achievable depends to a certain extent on whether the question is posed with respect to the real economy or the stock market. Though the two move in tandem over the long run, there is enough bifurcation in the current environment, both domestic and international, that suggests a soft landing in the real economy is more viable, albeit still difficult, than one in stock markets.
Indeed, the phrase “the stock market is not the economy” has been proffered many times when such dislocations between the two arise. We need only go back less than five years, to 2018, for the most recent non-pandemic year that witnessed such an occurrence. That year, the stock market (defined here as the S&P 500) fell by over 6% while the real economy (defined here as U.S. real gross domestic product) rose by nearly 3%. The conditions observed during that 2018 period go a long way in understanding why the real economy has a much better chance of executing a soft landing than the markets do this time around as well. Importantly, both 2018 and the current period share the characteristics of a Fed raising interest rates coupled with a firm underlying economy but inflated asset prices.
The most encouraging feature of the U.S. economy at present is the continued resilience of the domestic consumer. Though concerns over persistently high prices, that of gasoline in particular, and higher borrowing costs have dampened consumer confidence, they do not appear so far to have done material damage to consumers’ willingness to spend. The October retail sales report showed broad based increases in consumer spending over and above solely inflationary effects (i.e., real consumer spending increased). While inflation expectations have continued to increase marginally, there is reason to believe that the consumer may be able to hold out until the Fed is ready to stop raising rates. Estimates of the excess savings that consumers were able to build up during the pandemic suggest that consumers could continue to draw on those reserves well into next year.
This is an encouraging sign for hopes of a soft landing, but not without its risks. Consumers have been forced to curtail saving for the future in order to fund their current pace of spending. The personal savings rate is at its lowest level since the Great Recession. Credit card balances have been increasing even as interest rates have risen, indicating at least some consumers may have already burned through their excess savings. Furthermore, as mortgage rates rise the housing market will inevitably cool. Sharp declines in home values may put an end to the wealth effect tailwind for consumer spending. However, after having already endured a torrid pace of rising rates over the past nine months, another percentage point increase in borrowing costs should not, in and of itself, be expected to completely derail the real economy. So long as the labor market does not deteriorate significantly, consumers should be able to maintain the confidence needed to continue spending down their excess savings until the Fed is ready to land.
By contrast, the stock market may not be able to cope with higher rates as well as the real economy. Specifically, investors are more concerned with the “longer” aspect of the “higher for longer” mantra that the Federal Reserve has adopted. For example, suppose the Federal Reserve reached its expected terminal rate of around 5% in the middle of 2023, then announced it would hold for some time before deciding on whether to lower rates back down. Consumers would respond positively to such a development as it would coincide with lower inflation expectations and borrowing costs as well as stabilization in labor and housing markets. Investors, meanwhile, would only be left to ponder how long “some time” means and how quickly rates could be lowered once easing began. Market valuations are much more sensitive to, and adversely affected by, any delay in lowering rates than is the real economy.
There are also several noteworthy developments internationally that pose more downside risk to the markets than to the real economy. Russian shelling of the Ukrainian power grid and the killing of Iranian operatives in Crimea by Ukrainian military show that the war in Ukraine is far from over. However, winter’s approach provides a natural opportunity for a reduction in hostilities and the possibility of some sliver of rapprochement between Russia and Ukraine. A mere cessation of violence for a period of time would dampen uncertainty and alleviate some of the inflationary pressures confronting the real economy. Conversely, any signs of possible resolution would also likely lead some investor money to flow out of U.S. markets back to battered European stocks and currencies.
In China, there had been speculation that leaders were preparing to examine ways to relax their notoriously stringent Covid policies. The renewed surge in infections make such a relaxation in the near future unlikely. What’s more, recent protests that have caught some party leaders off guard may sour some on the notion of altering course as it could be seen as giving in to popular demand in a country notorious for its “Party knows best” stance. Any further lockdowns in “the world’s factory” during the critical holiday shopping season will only add to worries of a hard landing for markets.
Both the real economy and stock markets can expect some turbulence in the near term. However, as the Fed gains another quarter of visibility on the inflation picture this coming year, they will likely slow and then pause their interest rate hikes. The real economy will likely benefit from knowing that peak rates are behind them. Markets will require more certainty on the path of future rates before they display the same exuberance. Equities of large U.S. multinationals will also be buffeted by developments in Europe and China. A soft landing is not out of reach, but the real economy appears much better positioned to achieve one than the stock markets.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.