The US economic outlook has deteriorated compared to six months ago. Most people now believe that we’re in for a period of negative growth over the next three quarters. The question is whether the economy is in for a soft landing or a hard one. Either way, we think high inflation will keep the cost of capital elevated until 2024.
- The outlook for the US economy worsened in the past six months; the consensus view now points to negative Gross Domestic Product (GDP) growth over the next nine months. Why? Because just as the Federal Reserve’s aggressive rate hikes seemed to be cooling economic activity as intended, a side effect erupted: The collapse of Silicon Valley Bank in March put pressure on regional banks to tighten lending standards, further reducing the availability of credit, especially for small- and mid-size businesses.
- The main question today is whether we will experience a soft landing or a hard landing.
- The argument for a soft landing is that the commercial real estate sector (CRE)—which depends in no small part on regional-bank lending—is much smaller than residential housing, and hence the negative effect of CRE market dislocation would be smaller than during the Global Financial Crisis (GFC) in 2008. Also, the US banking sector’s share of total lending to corporates and consumers is now smaller than it used to be.
- The argument in support of a hard landing is that the lagged macro effects of the ongoing banking turmoil are larger than the consensus thinks. Inflation is also stubbornly high because of continued labor shortages and a recovering housing market, and that means higher rates for longer.
- We agree that a recession is coming, with the odds currently tilted towards it being deeper or longer than the consensus expects (we see a 60% chance of a hard landing).
- With inflation still at an annualized 5% (because of tight labor markets and a recovering housing market), we expect the Fed will need to destroy more demand in the economy to get price increases down to its 2% target. If so, the cost of capital will likely stay higher for longer than the market is currently pricing. We now expect the Fed will only start cutting rates in 2024.
- In this environment, portfolio positioning, in our view, argues for exposure to asset classes that have historically shown lower levels of volatility relative to public equities and lower sensitivity to inflation, such as private equity, private credit, and real assets. Investors who can act as providers of capital—especially debt and equity financing—can benefit from opportunities generated by an environment where regional banks remain under pressure and primary high-yield issuance continues to face headwinds.
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