The Big Economic Cycle Reset

The financial market seems to be experienced the final stage of the long interest rate cycle that has lasted 41 years. From 1981 to 2020, US 10-year government rate was 15.7% (1981) and reached a minimum of 0.55% (2020).

The ever-lower interest rates trend created a beneficial financial environment where continuous US productivity gains due to technology and innovation supercharge the economy and all assets' prices.

As US 10-year treasury interest rate was close to zero in 2020 (0.55%), US public and private debt have increased rapidly, inflation shot up to unseen levels since 1970, and the US economy reached an inflection point for the long interest rate cycle.

The interest rate hike of December 2021 could have started a new uptrend cycle for interest rates. This new cycle might stop when the Federal Reserve decides the balance between demand and supply of products and services has returned to normal, or the risk to the economy of higher interest rates becomes too high to bear due to unacceptable higher unemployment.

An increasing interest rate period is usually associated with a challenging economic environment, where companies must prove their worth and generate positive cashflows without the help of easy financing and lenient investors.

It is also where consumers are challenged because they might face several headwinds simultaneously. Recently, these are higher financial costs of loans, higher product and services prices due to inflation, lower asset prices for investments, and a less favorable job market.

As the US dollar is the global reserve currency, tightening US financial conditions also affect other countries' economies. Most foreign central banks might need to increase their interest rates to keep the value of their money. While a few foreign central banks might decide to easy financial conditions, it all depends on their specific circunstances.

The biggest problem is what happened in the following months and years. Although US productivity gains and innovation remain intact, the financial conditions might affect asset prices in the short term.

We now foresee a couple of future scenarios based on the expected rate of change in US economic growth, US inflation, US unemployment, and possible Federal Reserve actions. Based on the most likely scenarios, we select the appropriated investment allocation across the asset classes, US Stocks, international stocks, US bonds, Corporate Bonds, and others.

Since the start of 2022, the US economy has been drifting towards stagflation, meaning the economy has a lower growth rate and high inflation but still has low unemployment. The good news is that the US unemployment rate is healthy. So technically, we are not in stagflation yet. So far, the US economy continues to adapt to higher interest rates and food and energy costs.

If we continue this path, the Federal Reserve might keep tightening financial conditions, i.e., more interest rate hikes to reduce aggregate demand. The current strategy of the Federal Reserve is to set US short-term interest rates to an "equilibrium level" until inflation reaches its desired economic target of about 2%. After achieving such an equilibrium, this might be the soft landing expected if the unemployment rate stays low but most likely higher than current levels. This is the Goldilocks scenario.

A pause in the Federal Reserve interest rate hikes is also possible. Let us call it a Wait and See scenario. The Federal Reserve might change its mind sooner than expected by markets. The unemployment rate might spike faster, and the political and public pressure could increase so that they could be "incentivized" to pause its interest rate tightening cycle, even with persistently high inflation. In this scenario, the Federal Reserve might wait and see before acting again, seeking new data points for US economic growth and inflation. This scenario might affect the value of the US dollar vs. other currencies and other unforeseen effects.

There is also the possibility that the supply chain-related effect of excess inventories impacts inflation quickly. This will be a Bullwhip scenario. A deep and sudden drop in US economic activity develops fast. A deflation shock might occur due to diminishing consumer and business demand and excess inventories and supply of products, causing a deflation or a sudden drop in prices. Therefore, the Federal Reserve might stabilize its financial condition faster than anticipated, quickly lowering interest rates and stopping any sale of its government bond portfolio. It might be a surprise to go so quickly from a high inflation environment to the opposite situation, a deflation, but it is a not-so-distant possibility.

An unexpected external shock is also within the cards, a black swan. An event or a series of unforeseen circumstances might overnight reduce the global demand for goods and services, tipping foreign economies into crisis. In this case, the Federal Reserve might require balancing the effect of these external events on the US economy and acting accordingly, most likely reversing course.

As you may notice by now, markets may react quickly to expected changes in economic conditions. So, in the short-term, variations of each investment seem counterintuitive. Even under financial stress conditions, the market may react positively for a period.

Of course, financial market conditions might change in the blink of an eye, or they could sustain longer than anyone could expect while the market tries to decipher the most likely scenario. Better be prepared, and alert to the development as we are, to face the uncertain times ahead.

As usual, I am open to discussing these matters at any time for all my clients. For everybody else, it is never too late to join us.

Michele Lopez