Central banks across developed markets have synchronised their approach on monetary policy. While the onset of the steepest tightening cycle in a generation varied, a more united sense of purpose is now underway with the end of rate hikes coming into view.
The challenge going forward is for central banks to convince financial market participants that they will remain focused on their price stability mandate, even as economic growth falters both in the US and globally. So far, the message from monetary policymakers has been clear; rates will be higher for longer.
Comments made by central banks indicate a clear understanding that progress towards the long-term inflation targets is not assured and there are still risks to higher inflation.
For example, Christine Lagarde, president of the European Central Bank, stated that “rate cuts were not discussed, and it would be totally premature to do so.” Andrew Bailey, governor of the Bank of England, mentioned that “we’ve still got a long way to go in the battle against inflation.” Lastly, Jerome Powell, chair of the Federal Reserve Bank, stated that “we are not confident that the benchmark rate is sufficiently high to reduce inflation to 2%”.
Policymakers face an uncertain path going forward. If they continue to raise rates too high, the global economy could falter and enter into a recession. On the other hand, if rates stay low, inflation could spike anew.
This risk is amplified by the fact that global inflation has been trending down from its peak, creating an impression that the risk of insufficient interest rate increases is now relatively comparable to, or no longer outweighs, the risk of excessive rates.
This inflection point is a tough one to navigate. It supports a cautionary stance of pausing with no immediate plans of cutting rates. This approach allows time to closely monitor the variable and lagging effects of current rates levels on the economy, which in turn allows policymakers to avoid both the risk of being misled by a few good months of data and the risk of over-tightening.
Higher rates will inevitability have long-term effects on both fiscal spending and financial markets.
A note to fiscal policymakers – without effective policy measures to reduce government spending or increase revenues, higher rates will mean that fiscal deficits for countries will remain elevated due to higher interest payments. This would significantly weaken long-term debt affordability.
Investors should also be aware of the implications of higher rates on their investment portfolio. In the US, the Fed’s preferred measure of inflation, core personal consumption expenditure (core PCE), moved down to 3.7% in September, the lowest since May 2021.
The Fed Funds rate is now 1.6% above core PCE, the most restrictive monetary policy seen since 2007. Restrictive monetary policy means tighter financial conditions and may force consumers to cut on spending, creating a negative loop for company revenues and capital investments.
Historically, there has not been an occurrence where central banks succeeded in reducing inflation to the extent achieved thus far without a concurrent recession. However, some supply-side improvements, such as the easing of pandemic bottlenecks and an increase in workforce participation are helping to keep economies from substantially weakening.
As a result of some of these peculiar economic adjustments, there continues to be a glimpse of hope that policymakers will continue to get inflation down without a recession, and ultimately achieve what is known as a ‘soft landing’ or ‘the golden path’.
This optimism of a soft landing has continued to sustain equity markets with double digit year to date returns. This in itself has created relatively easy financial conditions which may continue to fuel inflation.
The base case remains that reducing inflation is likely to require a period of below potential growth and a softening of labour market conditions. This will mean rates may need to go even higher to tighten even more sharply to achieve these levels.
Higher rates will slow economic growth, which will be a headwind to risk assets.
A sharp tightening of financial conditions would strain weaker financial services companies already facing higher credit risks.
Surveys from several countries already point to a slowdown in lending, with rising borrower risk cited as a key reason. Many financial services companies will lose significant amounts of equity capital in a scenario where high inflation and high interest rates prevail and the global economy tips into recession.
Investors should scrutinise the prospects of companies with stock-market capitalisation below the value of their balance sheets, which has an impact on corporate funding.
Outside of financial services companies, fragilities are also present for companies with low interest coverage ratios, high and deteriorating short-term debt ratios, and high cash flow volatility. This group of companies faces intense pressure under slower economic growth and prolonged higher interest rates. Investors should exercise caution around these companies.
The bottom line is that monetary policy is more likely to be at peak levels in nominal terms, but additional tightening, if needed, is likely to come by keeping rates higher for longer.
Whether further tightening of monetary policy is required to ensure that inflation returns to target in a reasonable timeframe will depend upon the data and the evolving assessment of risks.
The ultimate path of monetary policy is dependent on stable macro readings like growth domestic product (GDP) and weakening inflation trends which includes readings from payrolls and core PCE.
It is still far too early to call an all-clear or to start extrapolating far into the future.
In the US, delinquencies on credit cards and auto loans are rising whilst savings rates are dropping faster which is helping to keep investor sentiment low.
Heightened uncertainty about the medium-term outlook can be seen in most companies’ earnings calls.
Despite recent strong results evidenced by more companies reporting higher earnings than expected, revisions have been weaker than normal, and guidance about future earnings has weakened. Corporate executives are talking more about potential exogenous headwinds like broad economic slowdown.
Investors should remain nimble and skeptical about premature forecasts of rate cuts as rates may remain higher for longer.
Richard Maparura is a Senior Portfolio Manager, Asset Management, Butterfield.
Sources: Bloomberg Economics
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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