eBusiness Weekly
Until now, the US economy has been unwavering, with solid employment figures of around 400 000 new jobs per month. At an unemployment figure of only 3,8 percent, we can consider the US as “fully employed”.
This leads us to believe the US economy will stay stronger for longer. But will it?
Ever since Covid-19 and the following stimuli that governments across the globe broadly introduced, inflation risk became top of mind for many analysts and rightly so.
With real interest rates in negative territory within major economies and money flowing into the system, prices of goods broadly were bound to move upward, leading to inflation.
Fuel was added to the fire due to the US raising interest rates late and the outbreak of the Russian-Ukrainian war that pushed food and oil prices (and everything linked to oil and transport) upward and beyond the wildest expectations of most of us.
The world entered a phase of hyperinflation, and aggressive interest rate hikes were on the cards. This became crucial to curb inflation. To curb inflation, economic growth and consumerism need to be cooled down.
In simple terms, people must have less disposable income, and unemployment must increase to reduce the money in circulation.
The theory is that fewer goods can be bought with less money in circulation, reducing demand and lowering prices, leading to lower inflation.
With the US “fully employed”, how is this playing out?
As with most things in life, there are different thoughts regarding a (US in particular) economic retraction or recession.
Some believe the US economy is in for a hard landing (severe recession), some believe a soft landing (mild recession) is on the cards, and others say the US economy will continue to prosper. I mainly focus on the US since the US economy drives the world economy.
We have noticed so far this year that the volatility of most asset classes is high. We also note that consumers are becoming more nervous as volatility increases. The S&P 500 experienced a retraction of 7 percent since its high in June this year.
If the US is “fully employed”, why is volatility increasing?
There are a few factors to consider:
Equities is only one asset class and competes with all the other asset classes on a global scale. Even though the S&P 500 is the world’s major stock exchange, global investors consider assets across the globe. Even after the recent retraction, the S&P 500 is still considered expensive.
Many investors favoured European and Japanese stocks over US stocks, which shows in their returns.
Price matters. However, Europe is showing strain due to China’s economy opening slower than expected (even though the Chinese economy is slow, it is still expected to grow by 5 percent, much higher than most economies…)
Due to increased pressure from the fully employed labour market to increase wages and shorten work weeks (we have started seeing labour action and strikes in the US to enforce this) and lower demand, especially from China, which has imported fewer goods from the US over the last year compared to the previous 12 months, as well as increased financing costs for companies due to higher interest rates, profit margins are being squeezed.
Lower profits lead to lower dividends. Dividends compete with bond yields and interest earned from cash.
With US bond yields substantially higher than 12 months ago, they are becoming a viable alternative to US equities with less perceived risk. (I say perceived risk because bonds are not risk-free).
With 1 year Treasury Bills at 5,4 percent and 3 year Treasury Bills at 4,8 percent, one can understand if more conservative investors are forced to invest in US equities for some years due to cash and bonds providing negative yields. Especially if a recession is still on the cards.
Bonds are also experiencing increased levels of volatility. Why?
Bond values, among other factors, broadly increase and decrease inversely to interest rate movements.
Interest rates follow higher and lower inflation, meaning bond values will also move inversely to inflation. If inflation rises, interest rates move upward to curb spending and inflation, and bond values reduce (bond yields increase).
If inflation decreases, interest rates move downwards to encourage spending and drive the economy, and bond values increase (bond yields decrease).
Investors were bullish on US bonds and believed that US interest rates were bound to start moving downward because of the satisfactory reduction of inflation.
However, with the Fed’s recent hawkish view of US inflation, the market believes that interest rates will likely stay higher for longer and even move upward if inflation does not reduce to the expected 2 percent.
Expect the switch between US equities and US bonds to continue, which will lead to heightened levels of volatility.
Is a US recession on the cards? I don’t know, but consider the following:
Although not flawless, the US probably has “the cleanest dirty shirt in the world”.
Europe is straining due to a slower Chinese economy.
40 percent of the Chinese economy is related to fixed property and fixed capital.
The Chinese government is not stimulating the economy. The other 60 percent can pick up quickly, but at a lower GDP.
The Chinese people are savers with lots of cash ready to be applied.
Within the next 18 months, between US$800 billion and US$1 trillion in corporate debt will be rolled.
Will this lead to an over-supply of bonds?
US corporate business debt, credit card debt and auto loan delinquencies are rising. Credit card debt of US under 35s is at GFC (global financial crisis) levels, leading to defaults. Credit was free for too long . . .
US insolvencies are increasing due to higher interest rates and higher business costs.
Leveraged companies may have a problem.
The US is running a 6 percent budget deficit.
The question must be asked: Is something going to crack? If yes, what?
This does not mean that you must move to cash. It merely means that you must understand what you are invested in and the characteristics of those investments.
Even though bonds are volatile now, the yield you buy is guaranteed (if the issuer is around to honour the coupon). Equities provide the best probability to beat inflation if given time, irrespective of their volatility during times of crisis.
Select your fund managers with care, trust them and stay invested. — Moneyweb
