Is a seemingly resilient America starting to show signs of cracking?

In a recent report by the International Monetary Fund (IMF), total global stimulus measures between January 2020 and April 2021 amounted to nearly $11 trillion, with the United States alone deploying $5.3 trillion. This means that just over 4% of the world’s population (US) received nearly half of this global stimulus.

During the same period, the Federal Reserve increased its holdings of public debt by $4.8 trillion. It is therefore unsurprising that the world’s largest economy has remained resilient, even amidst the steepest rate hiking cycle in history.

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In 2023, US GDP growth exceeded expectations, driven by consumers utilising a significant portion of the over $2.25 trillion in surplus savings accumulated during the pandemic and subsequent recovery.

The combination of locked-in low-rate mortgages, and a strong propensity to consume proved advantageous for the US economy.

While the concept of American Exceptionalism, the idea that America is innately exemplary when compared to other nations, has often been cited as a factor in America’s sustained prosperity, it’s crucial not to overlook the substantial fiscal support that has been sustaining the economy.

As the biggest and brightest shining star for capitalism, America has historically enjoyed the privilege of low borrowing costs. However, America’s recent rapid decline in its fiscal position has been noted by global ratings agencies.

Ratings downgrades

S&P and Fitch have already downgraded American long-term credit, with Moody’s recently lowering its outlook from “stable” to “negative”. America may slowly be losing this privilege of low borrowing costs, as subsequent ratings downgrades will likely increase the US government’s cost of borrowing.

In the current year, the United States incurred interest payments of $659 billion, nearly double the amount from just two years ago.

Economists project that if the current trend continues, interest payments could within the next three years become the US government’s second-largest expenditure item, following Social Security.

Given the upcoming elections, the Democrats are unlikely to embrace fiscal restraint. Whilst the economy has been resilient, opinion polls show that the average American disapproves of Joe Biden’s handling of the economy (even after being presented with information illustrating the economy’s resilience). The cumulative effect of inflation has resulted in “Bidenomics” being a non-starter.

Corporate America is eagerly anticipating Trump tax cuts, should the Republican front-runner prevail at the ballot box next year.

Long and variable lags

Economist Milton Friedman first coined the term “long and variable lags”. Friedman is said to have explained the issue of long and variable lags using the analogy of a shower with unreliable controls for the hot and cold water. A person turning on the shower might adjust the taps trying to achieve a comfortably warm setting. Cold water in the pipes may result in the shower-taker turning the heat up again, after which…with a lag, the shower-taker may find themselves scalding.

Economists widely agree that the impact of interest rate hikes may take between twelve and eighteen months to fully manifest itself in the economy.

Currently, the effective federal funds rate is at 5.33%, compared to 3.83% twelve months ago. This suggests that there might still be 150 basis points in hikes yet to be felt by the economy. It is notable that the federal funds rate peaked at 5.25% just prior to the 2008 global financial crisis.

Mary Daly, the president of the San Francisco Fed, has recently cautioned against prematurely declaring victory over inflation, emphasising that having to raise rates again (after cutting) would undermine the central bank’s credibility.

The market is already “fighting the Fed” by pricing in rates cuts that defy the Federal Reserve’s “higher for longer” narrative. Stickier goods inflation is likely to persist due to the ongoing reshaping of global trade following recent supply-side shocks. The current trend of near-shoring and friend-shoring has led to production relocating to higher-cost locales, emphasizing the increasing importance of supply reliability.

Sustained elevated interest rates

The Federal Reserve’s own projections indicate an anticipation of sustained elevated interest rates, coupled with a forecasted downward trend in inflation. As the gap widens between interest rates and inflation rates, real rates rise.

Should the Federal Reserve’s projections unfold precisely as anticipated (bearing in mind that they don’t call economics the “dismal science” without good reason), the United States will witness real rates reaching a level reminiscent of the period just before the 2008 Global Financial Crisis.

Consumer weakness is already starting to emerge, with delinquency rates recently starting to trend upwards.

Historically, the Fed has tended to pause on suspicion that it has already gone too far. It is notable that the last five times the Fed paused at the end of a rate hiking cycle, the S&P500 reached all-time highs, but four of those events ended in recessions.

At the time of writing, the S&P500 (driven primarily by the outsized gains of the magnificent seven) is up 19% year-to-date, just 6% away from all-time highs… whilst the equal weighted S&P500 is nearly flat year-to-date, up just 3.5%.

Should signs of vulnerability emerge, the initial indicators are likely to manifest in the labour market. We recommend closely monitoring the Sahm Rule, named after Claudia Sahm, a former economist at the Federal Reserve.

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Sahm’s research resulted in the development of the Sahm Rule, a tool with the capability to identify every recession since 1960 in its early phases, without producing any false positives. Sahm stumbled upon this insight while working on a benchmark designed to proactively initiate automatic stimulus payments to shield individuals from the impact of recessions.

According to the Sahm Rule, a recession is identified when the unemployment rate rises by half a percentage point from its lowest point in the preceding twelve months.

To enhance precision, both the current unemployment rate and the trough are calculated as three-month moving averages. The rationale behind the Sahm Rule is grounded in the concept that once the economy begins to decline, the decline tends to persist due to a demand-side feedback loop.

Source: https://www.economist.com/finance-and-economics/2023/11/14/america-may-soon-be-in-recession-according-to-a-famous-rule

At present, the Sahm indicator stands at 0.33%. It would not take much for it to reach the 0.5% mark. If the unemployment rate which reached 3.9% in October rises to 4% this month and 4.1% next month, the economy would, according to the Sahm rule, fall into a recession.

Source: https://fred.stlouisfed.org/series/SAHMREALTIME

A caveat however is that the current increase in unemployment appears to be because of an increase in the supply of labour, and not a decrease in the demand for labour.

Although the much-anticipated recession has been deferred, it would be a bold assertion to declare that it will be denied.

Kyle Coertze is an investment analyst at Cartesian Capital.