Soft US economic landing unlikely – investors take caution

PSG Wealth CIO Adriaan Pask cautions investors to be aware of the dangers of over-optimism regarding US earnings prospects and equity valuations.

One of the great paradoxes of the last year is the resilience of the US economy, despite record levels of debt and the steepest interest-rate hike cycle in four decades. In the last year interest rates in the US have increased 22-fold from 0.25% to 5.5%. Yet US unemployment is at 3.8% – the lowest it's been in 70 years. This seems remarkable, but whether it is sustainable remains to be seen.

With such a sharp rise in interest rates, one would expect economic growth to suffer. However, the US’ economic growth rate is currently standing at around 2.5% per annum, which is still good, considering that economic growth in a developed market like the US is typically around 2%.

Currently, there is a disconnect between what we are seeing in terms of monetary policy and increasing interest rates, and actual economic performance.

This is attributable to a lag effect. Interest rates have increased at a breakneck speed and typically interest rate increases take time to filter through the economy. Some economic indicators are more responsive than others, but for the full impact of interest-rate hikes to filter through into economic data can take up to 12 to 18 months.

To complicate matters further, there is also currently an anomaly in terms of where interest rates are and the performance of equity markets. Year to date the S&P 500 in dollar terms is up almost 20%. The market seems to be reflecting current economic data, as opposed to the interest-rate environment itself.

Cause for concern
Higher interest rates will ultimately impact US consumers’ disposable income over time, which in turn will hurt consumer spending. This will have a domino effect which impacts corporate earnings, which will have a negative knock-on impact on employment. This could signal tougher times ahead.

Looking ahead, we feel that an economic “soft landing” is unlikely. The interest-rate hikes that we've seen have been, quite frankly, just too drastic. While many economists feel that a softer landing – or potentially even avoiding a recession – is a possibility, given that economic indicators have held up so well, it is key to understand why they've held up so well.

COVID-19 savings buffer dangerously low
During COVID-19, there was significant governmental fiscal support to consumers to keep the economy afloat, but simultaneously consumers couldn't really get out of their homes to spend this money. As a result, savings rates and the accumulated pool of savings increased dramatically.

This has been a huge windfall for the US economy because, as interest rates rise, there is this buffer protecting the economy. That buffer was around $2 trillion at its peak, approximately 15 months ago.

Slowly and surely consumers have been spending this buffer as they needed it. This reserve is now 70% depleted, standing at $300 billion. Our sense is the minute that that is depleted completely, it will start to impact disposable income, which will translate into lower consumer spending and lower corporate earnings.

Against this backdrop, investors should tread carefully
History is filled with lessons – Microsoft from the late nineties into the early 2000s comes to mind. The stock defied valuations before crashing spectacularly in the dotcom crash. It took Microsoft more than 16 years to regain the valuation it held at the end of 1999. Through that whole period, Microsoft was a very successful business with solid earnings, yet it didn't really make for a good investment.

This is not too dissimilar from what we see happening with listed companies that are set to benefit from artificial intelligence (AI). Valuations have skyrocketed over the last eight months, fuelled by hyper-optimistic future expectations.

The risk of overpaying for these investments has increased dramatically, and the old adage “be fearful when others are greedy” rings true.