Where is the recession?

What if…

Future historians will not look back on this week and pay much attention to capital markets continuing to crash around like a wasp stuck in a jar. It will be the heart-rending scenes in Turkey and Syria, the grinding horror in Ukraine, or even the balloon furore that rightly take precedent. Investors continue to wait, impatiently, for the effects of that surge in real and nominal interest rates in the US and wider developed world of last year. The compounding impatience of the social media age has equipped us poorly to deal with the lag between cause and effect. Doubt begins to creep in – do higher interest rates really mean what theory thinks they mean? Charts circulate on social media purporting to show a positive relationship between higher rates and higher inflation (Figure 1). Meanwhile, incoming data, as usual not speaking with one voice, would seem to argue that the US economy may actually be accelerating, not slowing.

Our tactical asset allocation, one of the small parts of our multi-asset class funds and portfolios designed to take advantage of shorter term opportunities, is moderately positioned for darker times in the months ahead. This week, we look at where this could be wrong and the surging recovery in many of the parts of the market beaten up last year continues.

The effects of interest rates…

The textbooks are always capable of being wrong or out of date. Economies change for a start, meanwhile some relationships hold better in theory than in practice. It is also worth remembering that there are few, if any, cast iron certainties in the world of economics and markets. When searching for policies that work or don’t, we mostly look for statistical thresholds. How many times did a certain action do what we expected it to do across a range of circumstances, whilst controlling all the stuff that might also be influential. There is much, often well concealed, art in there.

The returning debate on the role of tax cuts and subsequent economic growth is a good example of the difficulties here. The advocates in the UK will point to a specific moment in post-war history when tax cuts could be linked to a subsequent recovery in growth. In the US too, this debate tends to cite a moment in history – under President Coolidge. However, on the other side, studies of the effects both across countries and within them find no meaningful relationship.[1] The problem here is generally how to isolate the noise and avoid muddling cause and effect. The evolving incentives of the private sector, the interaction of public and private investment, and the evolving technological frontier are just some of the factors at play.

However, with interest rates, inflation, and economic growth, there is perhaps a simpler story to tell. The starting point here is that longer term inflation is, in large part, driven by our collective expectations and how those expectations shape our wants and needs. In the shorter term, it is a necessarily messier business. For the most part, it is related to how fast the economy is travelling relative to how fast its engine is meant to go. This latter bit is tricky, as we’ve noted before. The optimal speed is always changing and is mostly unobservable. However, at any one time there are a finite number of workers and limits to how productive each worker can be. In theory, if you push too hard on those restraints, the price of them rises.

There is, of course, a link here to longer term inflation. Inflation today, however created, influences how we think about inflation tomorrow and beyond. We begin to change our behaviours and our expectations. So, central bankers step in and raise interest rates to cool demand for goods and services, to slow the economy and thereby cool our inflation expectations. A likely reductive and oversimplified explanation of a debate that still rages, but hopefully you get the idea.

There are some interesting counters to this, areas where higher interest rates could conceivably create more rather than less growth and/or inflation. Interest income rises in some corners. Meanwhile, higher interest rates can hit supply more than demand in certain corners of the economy. There are those who also argue that the period of ultra-low interest rates did more harm than good in many areas – lazy and poorly thought-out investment, speculative bubbles, and so on. However, the historical evidence overwhelmingly shows that the headwinds from higher interest rates ultimately dominate. When studying past interest rate shocks, production, employment, and ultimately inflation all fall in their wake.[2]

So, to today and the story of a surreally buoyant US economy. Could we be wrong – the surge in interest rates last year is absorbed without sweat. Yes, of course. There are always edge cases and the economy is not the machine of textbooks. Meanwhile, we should always be humble on the ever-changing pace that the economy is meant to travel at – multiplying technological wonders arriving on the scene could easily be shifting that pace materially among many other considerations.

However, our hunch remains that we are still in the no-man’s land, the lag, between cause and effect. Higher interest rates take a while to be fully absorbed into the economy. Not only do the latest employment and wage data (if taken at face value) suggest that central bankers in the US have quite a bit more work to do (Figure 2), but the effects of last year’s breath-taking surge in borrowing costs are still to be fully felt. In that context, we continue to lean against the sharp rally in stocks so far this year in our tactical portfolio and see merit in a little extra duration (long government bonds).

[1] William Gale & Andrew Samwick – The effect of income tax changes on economic growth – Brookings – 2015

[2] Michael D. Bauer & Eric T. Swanson - A Reassessment of Monetary Policy Surprises and High-Frequency Identification – NBER -?April 2022

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