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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is chief global strategist at BCA Research
If one places a warm glass of water in a freezer, its temperature will steadily decline. Eventually the water will freeze, turning from a liquid to a solid. Nothing new needs to happen to generate this “phase transition”. All that is necessary is for the temperature in the freezer to remain below zero degrees Celsius.
Now replace “temperature in the freezer” with “the level of interest rates”. The US economy is cooling in response to tight monetary policy, as evidenced by falling inflation and wage growth. It has not frozen over yet because it was running so hot two years ago. But if the economy’s temperature keeps falling, it will freeze over.
In early 2022, there were two job openings for every unemployed worker. Anyone who lost their job back then could walk across the street and find new work. This prevented unemployment from rising.
Things are not so simple any more. The job openings rate has dropped back down to pre-pandemic levels. Those who lose their jobs are finding it increasingly difficult to secure new ones. While an influx of people into the labour market has contributed to a rising unemployment rate over the past 12 months, close to half of the increase has been due to job loss.
A softening labour market will undermine consumer spending. The personal savings rate stood at 2.9 per cent in July, less than half of what it was in 2019. Excess pandemic savings have been depleted. In inflation-adjusted terms, bank deposits for the bottom 20 per cent of income earners are below where they were in 2019. Consumer loan delinquency rates have risen to levels last seen in 2010, a year in which the unemployment rate was double what it is today.
The housing market is showing renewed signs of stress. Homebuilder confidence dropped in August to the lowest level so far this year. Home sales are weak. Housing starts and permits have rolled over. The number of housing units under construction has declined by more than 8 per cent since the start of this year. Unlike in the past, construction employment has not fallen yet — perhaps builders are hoarding labour — but if housing construction continues to weaken, we will see a wave of lay-offs in that sector.
Commercial real estate remains under duress. Office vacancy rates are at an all-time high and are still trending upwards. Default rates are climbing in the office, apartment, retail and hotel segments. Regional banks, which account for the bulk of CRE lending, will experience more losses.
Manufacturing activity is slowing again. The new orders component of the ISM manufacturing index fell in August to the lowest level since May 2023. In real terms, core capital goods orders have been trending lower for the past two years. Construction spending has been subsidised by the stimulus provided by the Chips Act and the Inflation Reduction Act. While still high in absolute terms, this spending has peaked and will decrease over the coming quarters.
The Federal Reserve is unlikely to save the day. The economy succumbed to recession just months after the central bank started lowering rates in January 2001 and September 2007.
The market is currently expecting the Fed to cut rates by more than two percentage points over the next 12 months. Long-term bond yields will not fall much from current levels unless it delivers more easing than what the market is already discounting. That is unlikely unless there is a recession.
Even if the Fed does deliver more easing than is currently priced in, the impact will only be felt with a lag. In fact, the average mortgage rate that homeowners pay will almost certainly rise next year as low-rate mortgage debt rolls off and is replaced by that with higher rates.
In a recessionary scenario, we expect the S&P 500 forward price/earnings ratio to fall from 21 to 16 times and for earnings estimates to decline by 10 per cent from current levels.
This would bring the S&P 500 down to 3800, representing a nearly one-third drop from current levels. In contrast, bonds could do well. We expect the 10-year Treasury yield to fall to 3 per cent in 2025. Investors were right to favour stocks over bonds for the past two years. Now, it is time to flip the script.