Savings the key to a soft landing

Central banks have been tightening policy aggressively even as economic growth slows. The past week has offered signs that they are likely to continue to do so.

The Bank of England announced the largest rate hike since 1995 while projecting that the UK economy will enter a lengthy recession later this year. Despite the bleak economic outlook, further rate rises look likely in September, November, and December.

Federal Reserve officials pushed back against the market's dovish interpretation of their policy stance following the July FOMC meeting. San Francisco Fed President Mary Daly said the Fed is “nowhere near” finished with its fight against inflation while Cleveland Fed President Loretta Mester said she wants to see “very compelling evidence” that month-to-month price increases are moderating.

Several Fed officials have also cited the strength of the labor market as an indication that the US economy is not in recession despite two quarters of negative GDP growth. Friday's jobs report bore out this strength: nonfarm payrolls expanded by 528,000 in July, more than double consensus expectations, and the unemployment rate fell to its pre-pandemic low of 3.5%.

Two-year and 10-year Treasury yields rose 35bps and 20bps, respectively, over the week.

With inflation still high, we expect central banks to keep hiking rates aggressively.

With inflation still high, we expect central banks to keep hiking rates aggressively. But the tension between whether policy tightening will be accompanied by a soft landing with slower growth, or a more pronounced slump has been evident in financial markets in recent weeks.

After rebounding 9.1% in July, the S&P 500 climbed 0.4% in the first week of August, helped by an earnings season that has been more resilient than many investors expected. However, Brent crude prices fell nearly 10% last week to the lowest level since the start of the war in Ukraine, as fears of a global economic slump outweighed tight supply concerns. The US 2-year/10-year yield curve is at its most inverted since 2000, and such inversions have preceded recessions in the past.

These price developments reflect an unusual set of economic circumstances with a high degree of uncertainty about how they will be resolved:

• Lower saving by households is supporting consumer spending. The world economy is in a weird place. Unemployment in advanced economies is exceptionally low, but given high inflation, the real wage component of the US employment cost index is falling at the fastest rate on record. Consumer spending, however, is resilient. This unusual combination is partly explained by the willingness of advanced economy consumers to reduce how much they save each month, with lower savings providing more spending power to mitigate the effects of higher inflation.
• The eventual outcome could be a soft landing. In our view, a soft landing depends on real wages stabilizing before households’ savings run out. In this scenario, reduced savings (or increased borrowing) will fund consumption until real income growth stops being a drag on consumption. Given that the tight labor market has not translated into pay bargaining power in real terms so far, a soft landing is most likely if inflation falls, stabilizing real incomes.
• But the risk of a slump remains. If savings rates rise with real wages falling, an economic slump is likely. Why might savings rise? If the fear of unemployment becomes greater, households may increase precautionary savings. Alternatively, the need for consumers to save to repay the cost of previous expenditure—such as paying for summer holidays—may start a process of demand destruction.

With the outcome dependent on household savings behavior, a key risk is that consumers may change their behavior faster than in the past. This means agility will become an increasingly important characteristic of policy as central banks that are slow to grasp changes may risk overtightening. This point was driven home by Fed Chair Jerome Powell at the last policy meeting, when he stressed the central bank’s data dependency.

Against this uncertain backdrop, we suggest investors avoid positioning for any single scenario.

Against this uncertain backdrop, we suggest investors avoid positioning for any single scenario. Instead, they should ensure a robust portfolio that can perform in various outcomes. We prefer defensives, such as healthcare, as well as quality income, and value stocks, including global energy and the UK market.

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