Aug. 4, 2023
Stockmarkets, the economist Paul Samuelson once quipped, have predicted nine out of the last five recessions. Today they stand accused of crying wolf yet again. Pessimism seized trading floors around the world in 2022, as asset prices plunged, consumers howled and recessions seemed all but inevitable. Yet so far Germany is the only big economy to have actually experienced one—and a mild one at that. In a growing number of countries, it is now easier to imagine a “soft landing”, in which central bankers succeed in quelling inflation without quashing growth. Markets, accordingly, have spent months in party mode. Taking the summer lull as a chance to reflect on the year so far, here are some of the things investors have learned.
The Fed was serious…
Interest-rate expectations began the year in an odd place. The Federal Reserve had spent the previous nine months tightening its monetary policy at the quickest pace since the 1980s. And yet investors remained stubbornly unconvinced of the central bank’s hawkishness. At the start of 2023, market prices implied that rates would peak below 5% in the first half of the year, then the Fed would start cutting. The central bank’s officials, in contrast, thought rates would finish the year above 5% and that cuts would not follow until 2024.
The officials eventually prevailed. By continuing to raise rates even during a miniature banking crisis (see below), the Fed at last convinced investors it was serious about curbing inflation. The market now expects the Fed’s benchmark rate to finish the year at 5.4%, only marginally below the central bankers’ own median projection. That is a big win for a central bank whose earlier, flat-footed reaction to rising prices had damaged its credibility.
…yet borrowers are mostly weathering the storm
During the cheap-money years, the prospect of sharply higher borrowing costs sometimes seemed like the abominable snowman: terrifying but hard to believe in. The snowman’s arrival has thus been a double surprise. Higher interest rates have proved all-too-real but not-so-scary.
Since the start of 2022, the average interest rate on an index of the riskiest (or “junk”) debt owed by American firms has risen from 4.4% to 8.1%. Few, though, have gone broke. The default rate for high-yield borrowers has risen over the past 12 months, but only to around 3%. That is much lower than in previous times of stress. After the global financial crisis of 2007-09, for instance, the default rate rose above 14%.
This might just mean that the worst is yet to come. Many firms are still running down cash buffers built up during the pandemic and relying on dirt-cheap debt fixed before rates started rising. Yet there is reason for hope. Interest-coverage ratios for junk borrowers, which compare profits to interest costs, are close to their healthiest level in 20 years. Rising rates might make life more difficult for borrowers, but they have not yet made it dangerous.
Not every bank failure means a return to 2008
In the panic-stricken weeks that followed the implosion of Silicon Valley Bank, a mid-tier American lender, on March 10th, events started to feel horribly familiar. The collapse was followed by runs on other regional banks (Signature Bank and First Republic Bank also buckled) and, seemingly, by global contagion. Credit Suisse, a 167-year-old Swiss investment bank, was forced into a shotgun marriage with its long-time rival, ubs. At one point it looked as if Deutsche Bank, a German lender, was also teetering.
Mercifully a full-blown financial crisis was averted. Since First Republic’s failure on May 1st, no more banks have fallen. Stockmarkets shrugged off the damage within a matter of weeks, although the kbw index of American banking shares is still down by about 20% since the start of March. Fears of a long-lasting credit crunch have not come true.
Yet this happy outcome was far from costless. America’s bank failures were stemmed by a vast, improvised bail-out package from the Fed. One implication is that even mid-sized lenders are now deemed “too big to fail”. This could encourage such banks to indulge in reckless risk-taking, under the assumption that the central bank will patch them up if it goes wrong. The forced takeover of Credit Suisse (on which ubs shareholders were not given a vote) bypassed a painstakingly drawn-up “resolution” plan detailing how regulators are supposed to deal with a failing bank. Officials swear by such rules in peacetime, then forswear them in a crisis. One of the oldest problems in finance still lacks a widely accepted solution.
Stock investors are betting big on big tech—again
Last year was a humbling time for investors in America’s tech giants. These firms began 2022 looking positively unassailable: just five firms (Alphabet, Amazon, Apple, Microsoft and Tesla) made up nearly a quarter of the value of the s&p 500 index. But rising interest rates hobbled them. Over the course of the year the same five firms fell in value by 38%, while the rest of the index dropped by just 15%.
Now the behemoths are back. Joined by two others, Meta and Nvidia, the “magnificent seven” dominated America’s stockmarket returns in the first half of this year. Their share prices soared so much that, by July, they accounted for more than 60% of the value of the nasdaq 100 index, prompting Nasdaq to scale back their weights to prevent the index from becoming top-heavy. This big tech boom reflects investors’ enormous enthusiasm for artificial intelligence, and their more recent conviction that the biggest firms are best placed to capitalise on it.
An inverted yield curve does not spell immediate doom
The stockmarket rally means that it is now bond investors who find themselves predicting a recession that has yet to arrive. Yields on long-dated bonds typically exceed those on short-dated ones, compensating longer-term lenders for the greater risks they face. But since last October, the yield curve has been “inverted”: short-term rates have been above long-term ones (see chart). This is financial markets’ surest signal of impending recession. The thinking is roughly as follows. If short-term rates are high, it is presumably because the Fed has tightened monetary policy to slow the economy and curb inflation. And if long-term rates are low, it suggests the Fed will eventually succeed, inducing a recession that will require it to cut interest rates in the more distant future.
This inversion (measured by the difference between ten-year and three-month Treasury yields) had only happened eight times previously in the past 50 years. Each occasion was followed by recession. Sure enough, when the latest inversion started in October, the s&p 500 reached a new low for the year.
Since then, however, both the economy and the stockmarket have seemingly defied gravity. That hardly makes it time to relax: something else may yet break before inflation has fallen enough for the Fed to start cutting rates. But there is also a growing possibility that a seemingly foolproof indicator has misfired. In a year of surprises, that would be the best one of all. ■