Queen Elizabeth II’s mourning comes to an end, and with it, the thoughts of the war that continues to influence our economy and financial markets return. Despite this, the US, seemingly unaffected by the disarray present across the UK, Western Europe and even Asia, is instead thriving amidst the chaos. They can do this because the US energy security means it is exempt from the cost pressures the rest of us face. However, that being said, they are not entirely immune from troubles as inflation still remains a cause of concern for the US Federal Reserve (Fed). August’s consumer data illustrated a drop in oil-related pressure but a tightness in the labour market, resulting in the US facing a more structural inflation issue than Europe with wage-price-spiral dynamics.
While the Fed did loosen its grip on the US economy during the Summer, it will now have to tighten even harder in order to catch up with its previous complacency after the inflation expectations data. A recent Fed Open Markets Committee meeting is predicted to result in an increased interest rate of 0.75%, totalling the Fed Funds rate to 3.25%. Analysts are also suggesting the peak of the US interest rate to be around 4.5%.
Seasonally, consumer buying habits tend to be increased during the last quarter, especially with the Summer period being reduced as everyone felt the need to keep a tight grip on their wallets. It is yet to be seen whether or not this is just a delay, and the remainder of the year will be stacked up to make up for the lost time. The 0.75% increase in interest is expected to only be the start, and a larger rise of 1% would not be surprising.
US corporate credit shows few recessionary signs
Declining business confidence and the aggressive Fed has led to fears that debt repayments will become too great, sending companies into bankruptcy. The US is showing several signs of a recession, including the US yield curve (measuring the difference in payment terms between short and long-term government bonds) still being inverted, as investors are getting paid less to lend over ten years than two. On top of this, credit spreads (the difference between corporate and government bond yields) have fluctuated massively in recent weeks on the back of new inflation data. However, with last week’s inflation data still running hot, this widened further, leading to expectations of worse tightening of Fed than expected. This Fed tightening is only a result of a strong economy, spending consumers and good employment.
While spreads have widened, stress is contained for now, which is the biggest worry for a potential recession on the horizon. The high-yield credit speaks against potential recession fears, and without a sharp cost shock – like the one Europe is experiencing – economic strength should allow companies to deal with the rising cost of financing. The existing recession indicators are down are suspected to be a result of global and technical factors instead of a reflection of the US economy as a whole. The yield curve, for example, is skewed by the recent risk-off move from global investors – as many institutions are required to buy long-term US Treasury bonds.
Unfortunately, none of this is to say that things couldn’t take a turn for the worse. Sharp rate rises take a toll on businesses, and sectors like commercial real estate are particularly impacted by interest rate changes. That being said, it would take a significant weakening to create widespread pressure. By most measures, equities remain expensive relative to credit – despite the market falls this year. This could be read pessimistically as a sign that stocks need to sink further, but it could also indicate that corporate credit is undervalued, further reinforced by the balance sheet resilience. Market sentiment is the main difference between the two scenarios, and for better or worse, that sentiment will be a deciding factor in how corporate credit fares from here.
US midterms hang in the balance
The US midterm elections are less than two months away, and when this happens, the rest of the world will be watching. As such, it’s suggested that the midterms could be a time of volatility as capital markets are focused on money rather than political impacts. As recently as July, polling showed the Republican Party on track to regain control of the Senate, but with changing tides over the summer, the Democrats have seen their fortunes improve. The same can be said in the House of Representatives, just to a lesser extent. While a Republican victory seemed assured just a few months ago, it is now thought that President Biden’s Democratic Party will retain or even strengthen control of the Senate, with the Republicans expected to steal the House of Representatives away. Ceding the lower chamber would still frustrate Biden’s agenda and compound gridlock in Washington.
The ruling party’s fortunes can often be a good guide to the state of the economy. As mentioned, consumer sentiment dropped dramatically in the spring and summer, and the Democrats’ approval rating unsurprisingly fell with it. However, this swing may also be partly due to the Supreme Court’s decision to overturn Roe v Wade, the case which enabled nationwide access to abortion for the last 50 years. Which has actually, and worryingly for Republicans, seemed to have energised liberal voters. Unsurprisingly, Senate minority leader Mitch McConnell wants to steer the national conversation back towards inflation and the general economy.
The reality is actually that the midterms are unlikely to make any waves to change fiscal policy, at least not dramatically – especially when looking at the likelihood of a split and gridlocked legislature. Foreign relations could be a pivotal cornerstone for markets, especially that of China. The preference of Democrats or Republicans in Congress is hard to determine, and the recent swings haven’t had a big impact on asset market moves. Rather than the fiscal deficit, the trajectory for the current account deficit and the US Dollar may occupy investors’ minds.
This information has been provided courtesy of Tatton Investment Management’s newsletter.
