The equity market wants to have its cake and eating it too

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

US equity prices reached a new all-time high last week (see Exhibit 1). In our view, assets are pricing in a medley of seemingly contractionary futures. On one hand, equity prices are supported by expectations of a reaccelerating global economy. On the other hand, equities are supported by expectations for rate cuts by the federal reserve (and other central banks). The problem is, the latter requires a further decline in inflation, while the former would most likely lead to a reacceleration in inflation.

Exhibit 1: The S&P500 made a new all-time high last week

S&P500 Index

Source: Goldmoney Research

In the aftermath of the 2020 global Covid lockdowns, the world saw very strong economic growth, which was mainly a base effect. We can see this in commodity demand. Oil demand, for example, only reached 2019 levels by the end of 2023. In 2020, demand for oil, as for other commodities, plummeted at an unprecedented rate due to the global lockdowns. It took the three years of extremely strong growth numbers to get back to the previous highs. These were one-off effects and growth will be more in line with normal global economic expansion going forward. 

Thus, 2024 is set to be very different year compared to the last three years in our view. Global GDP growth has already slowed down meaningfully to just 3% last year. For this year, economists from the World Bank, IMF and investment banks are forecasting similar GDP growth. However, we think these forecasts are too optimistic. Several regions such as Europe and China have only started to slow down, and it is unclear to us why they suddenly should reaccelerate. Other regions such as the US still have a remarkably strong economy. But high interest rates are starting to take their toll. The two main regions of concern though remain China and Europe. 

We have discussed the Chinese economic situation in detail in a recent report  (see “China will not come to the rescue”, March 26, 2014). In a nutshell, unlike in almost all instances of a global economic slowdown over the last 25 years, China is unlikely to come to the rescue this time. We think at best, China will not drag the rest of the world down due to its own economic problems. So far, Chinese demand for commodities and foreign goods has held up well. However, it will be crucial that the political leadership manages to stimulate the economy without being able to rely on boosting the construction sector. 

The other struggling region is Europe. The GDPs of European economies have been on a sharp downward trend for much of last year. Germany is in a shallow recession for a year now. Other countries such as France and Italy held up better but are now close to contractionary territory as well. The Eurozone as a whole is still showing (barely) positive GPD growth but it’s now at the lowest level since coming out of the COVID lockdowns (see Exhibit 2).

Exhibit 2: GDPs of European economies have been on a sharp downward trend

Source: Goldmoney Research

Purchasing Manager Indices (PMIs) have also been on a downward trend. PMIs indicate economic trends. They are compiled by surveying business managers in the manufacturing and surveying sectors. Participants are asked about several indicators, whether they are improving or deteriorating, or have no changes. A number above 50 means expansion compared to the previous month, a number below means contraction and 50 means no change. European composite (manufacturing and services) PMIs are indicating contraction since the middle of last year. While the PMIs of some countries have rebounded slightly from their lows over the past months, they are still in contractionary territory, indicating continued contraction albeit at a slower pace (see Exhibit 3). 

Exhibit 3: European Composite PMIs indicate contraction

Source: Goldmoney Research

Manufacturing PMIs show an even more abysmal picture. Manufacturing PMIs showed a strong contraction last year. We believe this was mainly on the back of the European energy shock. European energy prices have sharply declined since and are close to historical levels. Yet European Manufacturing PMIs still indicate contraction (see Exhibit 4).

Exhibit 4: European Manufacturing PMIs show strong contraction

Source: Goldmoney Research

Interestingly, this weak economic environment hasn’t yet resulted in higher unemployment. Of the largest European economies, only German unemployment has gone up, but it is still well below the levels following the Covid lockdown, and much below the post-financial crisis levels (see Exhibit 5).

Exhibit 5: The weak economic environment in Europe hasn’t led to higher unemployment yet

% Eurozone, France, Italy (LHS), Germany (RHS)

Source: Eurostat, Goldmoney Research

This is not unusual for Europe. Unlike in the United States, employment is strongly lagging economic contraction. This is probably the result of much more stringent labor laws.

Importantly, we think Europe is not coming out of a recession, the recession is just starting. Arguably European gas and power prices are down 80-90% from a year ago and close to the historical range. At first sight this might suggest that the energy shortage that led to the current economic problems is behind us. But the reason why energy prices are lower is because demand has contracted so much. While the industry sector has done a tremendous job in implementing energy efficiency measures, a large amount of this industrial energy demand destruction is due to the permanent closure of manufacturing capacity as energy intensive production moved elsewhere. Hence, the normalization of European energy prices does not mean that the European economy will also return to normal. If it would, the energy shortage would return too. In our view, it is more likely that the effect of the loss of manufacturing capacity will have spillover effects on the rest of the economy going forward. We expect unemployment to rise going forward and we also expect a slowdown or even contraction in other sectors than the manufacturing industry. 

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 all of 2023. 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, millions of full-time jobs were lost over the past 12 months and were replaced with part-time jobs (see Exhibit 7). 

Exhibit 7. Headline US unemployment numbers hide the fact that five million full-time jobs have been lost over the past year

Thousand[41] 

Source: Goldmoney Research

Nevertheless, there isn’t a sharp increase in unemployment which is typical in an economic slowdown in the United States. This is remarkable given the sharp rise in interest rates since 2021. Historically, such a sharp rise in interest rates would have led to at least some slowdown in economic activity. We suspect that the economy is 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 business 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, mortgage interest payments are on a steep upward trend, up $120bn since the lows in late 202 (see Exhibit 8). 

Exhibit 8: Mortgage payments increased $120bn 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. The total amount of outstanding mortgages has ballooned to $21 trillion, 37% 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 sharp move lower in interest rates, household mortgage expenditure will almost certainly continue to rise for years to come. 10-year fixed rates are currently at over 6% and adjustable mortgage rates are even higher. So, if all of the outstanding debt had to be rolled at these rates, total residential mortgage payments would more than 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 is still quite low. A rise in unemployment 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 that are 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.

Source: FRED, Goldmoney Research

This means that the American consumer is facing much higher debt service spending while simultaneously inflation eroded 20% of the purchasing power of every dollar since 2020. 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. 

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. 

So why are equity markets at all-time highs? The reason lies in the market’s expectations for Fed policy. The cooling of the economy has also led to a slowdown in inflation. A year ago, inflation was at double digit rates. It has since then cooled to 3.2%. 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 start lowering rates. The Fed itself is also signaling rate cuts. This in turn has buoyed equity prices to new highs. 

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 is because the economy is slowing down. This will eventually have an impact on corporate earnings. 

Currently, the market expects 3 rate cuts by a total of 75bps in 2024. 0.75% lower rates will only partially offset the increased mortgage burden that arises from maturing debt. Credit card debt will also continue to rise faster than declining rates can offset total interest payments. 

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 5.5% in 18 months, we think it’s unrealistic that a 0.75% decline will move the needle for those firms much.

On top of that, it’s far from certain that the Fed will cut rates by 75bps in 2024. Market expectations have already changed quite dramatically, from 6 cuts in 2024 back in January to only 3 cuts now as inflation remained stubbornly above 3%. 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 impact company earnings. It feels like the US equity market wants to have its cake and eating it too.