Investor worries about the US Fed dragging global economy into recession seem misplaced

The analyst community spends significant time and resources trying to figure out the Fed’s next move. However, are all the resources allocated to this worth it? As with most things, it depends on what you do with the information.

For the majority of individual investors, Fed policies matter most when they reach extreme levels that are able to push the economy from an expansion to a recession or vice versa. Central banks use monetary policy to try to maximise economic activity and employment, while trying to avoid ‘excessive’ inflation.

We all understand why economic growth and employment are good - but why is inflation bad? There are several reasons:

* High inflation usually hits the poorest people the most as wage gains may fail to keep up with inflation;

* Inflation favours debtors over savers as the real value of debts and savings fall;

* Inflation becomes more volatile at higher levels, making planning harder for households and companies, potentially reducing the incentive to take risks; and

* It forces central banks to raise interest rates sharply to curtail demand growth, often leading to a recession and higher unemployment.

How does this apply to the current situation? In most developed economies, inflation is way above the levels that central banks are comfortable with, which are normally around 2 per cent. In the US, the Fed’s favoured inflation measure reached 5.4 per cent in February, the highest since 1983.

This was caused by several factors, which include: the huge global supply bottlenecks that have led to a shortage of goods; the significant pent-up demand in the economy following the Covid restrictions, which was also fuelled by the government’s Covid emergency handouts; and finally, the constrained supply of workers due to the impact of Covid, which has led to a tight job market and wage growth acceleration.

It is this latter point, together with the break higher in long-term inflation expectations, that got the US central bank concerned that we could be entering a self-feeding wage-price inflation spiral. This also explains the dramatic increase in expectations of interest rate hikes since the end of last year.

All this sounds worrying. It is possible the Fed could be overzealous in its attempts to control inflation, pushing the economy into a recession. While debt ratios have come down somewhat, aided by high inflation, they remain high in historical terms.

Reasons for optimism

Higher interest rates can put pressure on people’s ability to finance their debt, which could lead to more conservative spending and investment decisions, rising defaults and an economic recession. However, we see reasons to be more optimistic.

First, the US economy is still growing well above trend, and rising corporate profitability, strong job markets and rising wages should be able to sustain an increase in debt servicing costs.

Second, while the housing sector typically faces headwinds from rising interest rates on mortgages, the majority of mortgages today are fixed rate mortgages and not affected by rising interest rates. (Of course, rising rates will make it harder for new entrants into the housing market).

Third, even if the Fed hikes rates by another 1.5 per cent this year, in line with its latest forecasts, this would still leave ‘after inflation’ interest rates below zero, which means monetary policy will remain stimulatory, just less so than currently.

Fourth, if the economy starts to slow and unemployment starts to rise, we expect the Fed to start toning down its rate hike expectations, especially if inflation starts to come down as well.

Not close enough

Therefore, on balance, we do not believe we are close to the point whereby the Fed will tip the economy into recession. This is important for investors. It means that the recent pullback in equities is most likely a buying opportunity rather than something to be worried about.

Of course, markets could weaken further in the short-term depending on how the conflict in Ukraine develops and what happens to commodity prices, but it does suggest that pullbacks are likely to be transitory.

Our recommendation is that investors, who have yet to garner sufficient exposure to equities as part of their foundation allocation, use the latest market pullback as an opportunity to gradually add to their holdings. This is especially the case for Asian equities.

Led by China, the sell-off in this region has been more prolonged and severe and markets are looking particularly cheap and oversold. As the US dollar peaks, we expect Emerging Markets to recover more strongly in general, led by Asia (ex-Japan) equity markets.