Transitioning Paradigms: Navigating New Economic Realities

We stand on the precipice of a new economic era. The well-trodden paths of easy money, predictable inflation, and comfortable government deficits are coming to an end. The landscape is steering towards a new paradigm characterized by higher interest rates. The adaptation to this new terrain has been far from seamless with market participants, governments, and consumers alike reluctant to accept this new path. In reflecting on this transition, I am reminded of a quote from Itayi Granande: “A paradigm shift isa long-lasting change in the way we think about our lives. It's a shift in our perception of reality, a change in our beliefs and assumptions, and a new way of looking at the world around us.” Following this quote, embracing this transition isn’t just about adjusting to new norms, it involves redefining expectations for financial markets.  

Inflation: Peaked but Volatile

While inflation has likely peaked in the U.S., the retracement over the last several months has demonstrated that the journey to stabilization remains ongoing. Nominal wage gains are still above pre-pandemic trends and recent labor union victories won’t help matters moving forward. Looking to relevant metrics, both the money supply (M2) and the Velocity of Money (M2V) reiterate this. After falling rapidly for over a year, M2 has curtailed its decline, presently sitting around $20T. Meanwhile M2V, a measurement of the rate at which money is exchanged in an economy, has also reaccelerated.  

As a result, Core inflation, which removes more volatile components such as food and energy, remains stubbornly high. External factors, such as production cuts by OPEC+ and geopolitical strife in the Middle East, have driven oil prices higher, compounding the inflationary pressure as consumers are once again feeling the squeeze at the gas pump. As is typical when geopolitical tensions rise, the tragic events unfolding between Israel and Hamas will likely keep oil prices elevated in the near-term. With inflation remaining above the Fed’s 2% target, the Fed remains steadfast and resolute on its stance that elevated interest rates are appropriate and have signaled an additional raise is not out of the question.

Bear Steepener: Unpacking the Phenomenon

Recent trends in financial markets signal an alertness to the Fed’s cues, as evidenced by escalating bond yields for longer maturities. While the yield curve has been inverted since the middle of last year, a potentially more ominous sign is now forming: the “Bear Steepener”.  This indicates a scenario where interest costs (or yields) on long-term borrowings escalate faster than returns on short-term assets, tightening the financial noose.  

Typically, with an inverted yield curve, the curve un-inverts as the Fed loosens monetary policy and yields for bonds on the short end fall. However, we are presently facing a potentially protracted restrictive monetary policy from the Fed. Market participants, faced with a resilient economy, a strong labor market, and a stubborn Fed, are driving up longer-term yields in expectation of the transitioning paradigms. Given that many individuals and companies borrow on the long end (e.g., mortgages and corporate bonds) and save on the short end (e.g., money markets and CDs) of the yield curve, this indicates interest expense will outpace interest earnings. This shift could potentially throttle the economy, setting the stage for a lackluster labor market and even a recession.

Double Trouble: Government Fiscal Deficits Fueling Inflation

A consequence of the rising yields is the increased burden it places on government borrowing. While it’s true that we’ve been accustomed to operating on deficits, low interest rates have made debt service costs mostly benign. In contrast, today’s environment is unique with substantial interest rate hikes and a deficit that has doubled in the last year alone. With the U.S. debt-to-GDP ratio remaining at unprecedented post-pandemic levels, fiscal prudence is critical.  

The majority of the federal government’s commitments must adjust to account for inflation. With the surge in inflation, expenditures like those on Social Security and Medicare rise, along with the costs of other government procurements. Presently, the government’s spending velocity not only drives economic growth but also fans the flames of inflation.

The financial road ahead seems murky. If we sidestep a recession, escalating borrowing at lofty interest rates could usher in substantial deficits. Conversely, should we plunge into a recession, dwindling tax revenues in a flagging economy could lead to similar deficits. The lack of a consensus in Congress aggravates this situation, sidelining discussions on long-term challenges. As of 2023, federal expenditures are projected to comprise 23% of the GDP, a peak not seen since 2009 during economic contractions and high unemployment. With an expanding nominal GDP and unemployment below 4% today, any economic downturn could see limited federal intervention capabilities when they are needed most.

Facing Challenges: Cracks Mounting in a Resilient Economy

Despite the myriad of challenges, the U.S. economy has showcased remarkable resilience. Yet, several indicators hint at potential pitfalls ahead. Mounting corporate debt, credit concerns, and tightening lending protocols suggest that storm clouds may be gathering on the horizon. From a corporate perspective, the need to refinance with depressed revenues and higher interest rates is a recipe for defaults to rise.  From an investment standpoint, tightening lending standards typically forewarn high yield bond spreads. Given this, we await a more attractive spread as our entry point.

From the consumer’s perspective, stagnating real incomes and rising interest burdens further complicate the picture. Amid growing consumer debt levels, financial institutions are becoming more stringent with their lending criteria. Even though present statistics might suggest an optimistic scenario, when considering predictive economic indicators, the outlook seems less promising. In fact, Jamie Dimon, JP Morgan’s CEO, encapsulates this by highlighting the significance of future-focused metrics, cautioning against over-reliance on present date. He poignantly notes, "We've been spending money like drunken sailors around the world…To say the consumer is strong today, meaning you got to have a booming environment for years is a huge mistake.”  

Real Estate: Standing at a Crossroads

The residential real estate market is grappling with an affordability crisis, a reflection of which is the stagnation witnessed over recent months in the national single-family home market.  Led by rising rates, the average monthly payment for a new home has nearly doubled since the start of the pandemic. Ultimately, this has caused a plummet in the number of mortgage applications. This has a downstream effect where limited transactions then results in a lack of supply which keeps prices elevated.  As debt service costs to the consumer continue to bite, sellers seeking liquidity may be forced to substantially lower price expectations.  

The commercial sector, too, isn’t insulated from these pressures. In many major metropolitan cities, office towers remain underutilized and refinancing heavy debt loads at higher interest rates under depressed rent growth remains an impossibility.  However, this creates avenues for opportunistic real estate endeavors. For example, we have been fielding calls from investment managers seeking to purchase distressed office buildings at a steep discount to reposition them as multi-family condominiums.  Indeed, dislocation brings about opportunity.    

Rocky Terrain: Equity Markets Feeling the Pressure

The equity markets have felt the ripple effects of these changes, shedding some of the robust gains from earlier this year. Market breadth remains narrow as the “Magnificent 7” still account for nearly all positive returns YTD.

As higher interest rates take a bite out of consumer’s ability to spend, corporate revenues will fall. In fact, expectations indicate that corporate earnings will decline year-over-year for the fourth consecutive quarter. Though both the pullback and downward revisions help bring expensive valuations down to more reasonable levels, the present interest rate environment makes a strategic approach to equity investments paramount. From our perspective, the attractive ~5% yields across the fixed income spectrum suggest there is room to wait for equity valuations to become even more attractive before we go bargain hunting.

Conclusion

As we reflect on the unfolding economic landscape, it’s evident that we stand at a pivotal juncture in our financial history. The transition from an era of easy money to one of cautious tightening underscores the complexities inherent in today’s financial markets. From stubborn inflation and evolving interest rate paradigms to the nuanced challenges faced by consumers and federal institutions alike, it’s crucial for investors to remain both vigilant and adaptive. Drawing lessons from both current metrics and forward-looking indicators, it’s clear that a proactive, informed strategy is our best defense(and offense) in these dynamic times. While challenges abound, opportunities also await those equipped with the right knowledge and perspective. As we navigate this intricate terrain, we will embrace the future’s uncertainties and potential.