Equity investors want to have their cake and eat it – Part II

Equities are pricing in a goldilocks scenario where global economic activity reaccelerates while inflation declines further, allowing the Fed and other central banks to continue to cut rates. However, we think there is substantial risk to this view. 

In this two-part report, we will take a closer look at the dichotomy of the clear slowdown in global economic activity and the simultaneous rally in equities. In our view, there is no doubt that the global economy has been slowing down significantly for a while now. Oil demand has been weak in 2024 and is close to signaling a global recession. Europe’s economies have been doing particularly bad, but also China seems to have finally reached a point where the government cannot simply strongarm the economy back on track. The US has remained a bright spot in the world for most of 2024, and real-time data still doesn’t indicate it’s in trouble just yet. But the longer the rest of the world struggles, the more difficult it will be for the US to prosper on its own. Especially if now tariff wars are on the horizon. Meanwhile, equities, and particularly US equities are hovering near all-time highs. In our view, this simply reflects the markets’ expectations that the Fed, and other central banks, will continue cutting rates, while simultaneously the economy re-accelerates. While we think it’s fairly plausible that central banks will continue to cut rates, we believe it can only happen if inflation continues to decline. And, in our view, that can only happen if the US and the global economy slow down further. A re-acceleration of the economy is not just unlikely in our view, it would also push inflation up again. Hence, in our view, the markets seem to be pricing in two scenarios that are mutually exclusive. In the first part of the report, we discussed the economic situation in Europe and China. You find the report here: Equity investors want to have their cake and eat it – Part One, 31 January 2025.

With two major regions, Europe and China, facing a challenging near-term future, world economic growth hinges on the United States and the rest of the world. Arguably, the US economy has been on a tear the last few years. For example, unemployment is still exceptionally low (see Exhibit 6)

Exhibit 6: US unemployment remains near historical lows

%

Source: FRED, Goldmoney Research

However, while overall US unemployment hasn’t gone up much, close to three million full-time jobs were lost over the past 18 months and were replaced with part-time jobs (see Exhibit 7). 

Exhibit 7. Headline US unemployment numbers hide the fact that close to three million full-time jobs have been lost over the past 18 months

Thousand[41] 

Source: Goldmoney Research

Nevertheless, there isn’t a sharp increase in unemployment rates, which is typical in an economic slowdown in the United States. This is remarkable given the sharp rise in interest rates. Historically, such a sharp rise in interest rates would have led to at least some slowdown in economic activity. 

We suspect the economy to be much more insulated from interest rate hikes compared to the past. Close to 15 years of extremely low rates and the fact that the entire rate curve was that low allowed both businesses and homeowners to lock in low rates for an extended period. Hence, the sharp rise in both short- and long-term interest rates didn’t translate into a one-for-one increase in debt payments just yet. Nevertheless, quarterly mortgage interest payments are on a steep upward trend, up $166bn since the lows in late 2021 (see Exhibit 8). 

Exhibit 8: Quarterly mortgage payments increased $166bn since 2021

$ Million

Source: FRED, Goldmoney Research

Interest payments on mortgages will almost certainly continue to rise going forward as more fixed mortgages expire and need to be rolled into much higher rates even as FED funds rates have peaked. The total amount of outstanding mortgages has ballooned to $21 trillion, 40% above the levels prior to the subprime mortgage crisis (see Exhibit 9). 

Exhibit 9: Outstanding US mortgages are at an all-time high

$ Billion

Source: FRED, Goldmoney Research

Meanwhile interest rates are now at the levels last seen during the dot.com bubble. But outstanding mortgage debt is now three times as high. Unless we see a sharp move to lower interest rates, household mortgage expenditure will almost certainly continue to rise for years to come. 10-year fixed rates are currently close to 6% and adjustable mortgage rates are even higher. So, if all the outstanding debt had to be rolled at these rates, total residential mortgage payments would double to a whopping $1.2 trillion per year.

So far, this hasn’t led to a housing crash. The reason is most likely that homeowners are not yet in a position where they are forced to sell their homes. But there are quite a few reasons why this can change quickly. As we have mentioned above, unemployment rates are still quite low. A rise in unemployment rates as the economy worsens could force homeowners to sell as they can no longer meet payments. Another reason is the expiry of a fixed rate mortgage and the need to roll into a new mortgage at much higher rates. 

The problem is that homeowners trying to sell are facing potential home buyers that are unwilling and unable to buy in the current environment. According to the University of Michigan sentiment index, buying conditions for a home are at an all-time low. That is due to a combination of stubbornly high prices and high rates. As rates are unlikely to come off significantly – unless there is a deep recession – home prices would have to correct sharply lower for new buyers to jump in. 

Exhibit 10: Potential home buyers say current buying conditions are at all-time lows

Michigan University sentiment index: Conditions for home buying

Source: University of Michigan

At the same time, interest paid on credit card debt has exploded as well. After a brief period of declining outstanding credit card debt in 2020 on the back of the first lockdowns, credit card debt rapidly rose again in 2021 and is at an all-time high. And what is even more concerning, credit card debt is now rising much faster than it did any time since the great financial crisis. Simultaneously, interest rates on credit card debt jumped to multi-decade highs. This means that the amount of interest consumers pay on their credit card debt has risen dramatically, which exacerbates the speed at which new debt is accumulated.

Exhibit11: Total outstanding credit card debt is at all-time highs while credit card interest rates remain at over 20%

$ Million (LHS), % (RHS)

Source: FRED, Goldmoney Research

In other words, the American consumer is facing much higher debt service spending while simultaneously inflation has eroded 30% of the purchasing power of every dollar since 2020 (if you believe the official inflation statistics). For some time, US households were able to deal with this by running down excess savings that were accumulated in 2020 during the lockdown periods. But those excess savings are long gone and as a result, cracks are appearing in the shiny facade of the strong US economy. 

For example, delinquency rates on credit card debt and consumer loans are on the rise. While still much below historical levels, delinquency rates are on a steep upward trajectory. We believe that – absent some major changes in the environment – this will inevitably lead to a slowdown in consumer spending. 

Exhibit 12: After years of declining delinquency rates, both credit card delinquencies and small loan delinquencies are rising again

% in delinquency

Source: FRED, Goldmoney Research

There are also other signs that the US consumer is struggling due to the high rates and purchasing power erosion. Consumer sentiment for low-income households is not recovering in any meaningful way according to the Michigan University sentiment index. While the top third of households show steady signs of improvement in sentiment, the bottom third remains near record lows. We believe this is due to higher income households benefiting from higher stock and real estate prices while lower income households only saw price inflation without an equivalent adjustment of their salaries. 

Exhibit 13: Michigan Consumer Sentiment Index

Source: Michigan University, Goldmoney Research

So why are equity markets near all-time highs? In our view, the reason lies in the market’s expectations for Fed policy. The cooling of the economy has also led to a slowdown in inflation. Eighteen months ago, inflation was at double digit rates. It has since then cooled down to 2.9%. That is still above the Fed’s official target of 2%, but it is low enough that it has created strong expectations that the Fed will keep slashing rates. The Fed itself is also signaling this, although at a slower pace than we think the market is pricing in. This in turn has supported equity prices. 

One can argue that lower rates – all else equal – should have positive effects on asset prices. But it seems extremely optimistic to assume that all else will be equal. The problem is that the only reason why the Fed would be able to lower rates without any impact on inflation is because the economy is also slowing down. This will eventually have an impact on corporate earnings. 

Currently, the market expects 1.5 more rate cuts by the end of 2025 and a further rate cut in 2026. At the same time, more debt will mature and will be rolled into a much higher rates than what is[42]  expiring. This will continue to burden the US consumer. 

And it’s not just the consumer that faces these issues. While large multinational corporations currently benefit from higher rates as they sit on trillions in cash that finally generates interest against mostly long-term debt obligations, smaller companies and newly founded firms are suffering from high rates. As rates went from zero to 4.25% in two years, we think it’s unrealistic for a 0.375% decline to move the needle for those firms much.

On top of that, it’s far from certain that the Fed will cut rates by 0.375bps in 2024. Market expectations were for 6 cuts for 2024 a year ago, but ultimately the Fed cut only 3 times as inflation remained elevated. But this didn’t have a negative impact on equities at all. 

In our view, equities are pricing in a world with much lower rates. This would require sharply lower inflation. The only scenario in which we think this is possible is if the US falls into a recession. This would have an impact on wages as well as rents and commodity prices. But above all, it would also have an impact on company earnings. It feels like the US equity market wants to have its cake and eating it too.

 [41]Verstehe nicht genau was das ist. Die Zahlen unten sind bereits als Tausend angegeben.

 [42]???