The soft landing is within sight but not guaranteed
Posted on . 4 min read
Ever since interest rate hikes began in 2022, economic pundits have wondered whether the U.S. would be able to achieve a “soft landing.” In other words, would raising interest rates inevitably crash the economy? Or would the Federal Reserve succeed in slowly deflating overpriced assets, steering the economy toward a healthier future?
Interest rates are now at the highest level in 22 years, and the Fed has hinted it will hike them even higher. So where do we stand now? Things look good — really good, actually. The U.S. stock market is hovering near all-time highs, with the S&P 500 having fully recovered from a 25% dip in the first nine months of 2020. The U.S. still has a historically low unemployment rate of around 3%. And interest rate hikes have largely had their desired impact: inflation is down to just 3% from a high of 9% in 2022.
Despite all the positive signs, it’s still too early to declare a successful soft landing. If the economy were a SpaceX Falcon 9, it would be hovering close to the launchpad with the rockets still firing away. There are simply too many unknowns to give the all-clear signal. To list a few:
- China’s economy is teetering on the brink of a debt crisis. You may have seen Evergrande in the news recently. It’s a Chinese real estate developer that ran into a huge debt problem (to the tune of $340 billion) since it kept building new real estate projects using leverage, anticipating China’s middle- and upper classes would always demand more. Of course, as soon as the Chinese economy hit a rough patch, the demand shrank, and Evergrande ended up defaulting on billions of dollars in debt. The government intervened and helped to stabilize the situation. Still, the Evergrande story speaks to China’s debt problem and the lingering impacts of COVID lockdowns. The youth unemployment rate sits at over 21%, contributing to social unease. Any financial crisis in China would undoubtedly spill over to global markets, given China’s status as “the world’s factory” and the second-largest economy behind the U.S.
- Decoupling from China. America & other Western economies continue to decouple from China. This is resulting in more in-shoring & near-shoring, as witnessed by Mexico’s climb to the top position as a US trading partner. China’s cheap labor + capital, coupled with lax environmental standards, kept inflation artificially low for much of the developed world over the last few decades. It remains to be seen how inflation will play out once this decoupling has run its course.
- Important economic indicators are still flashing red. The U.S. bond market yield curve remains inverted. This happens when short-term bonds have a higher yield than long-term bonds, meaning investors are worried about longer-term uncertainty (hence higher short-term rates), but are confident of longer-term stability (hence lower longer-term rates). Reading between the lines, investors are worried about near-term problems such as debt and inflation, but they maintain confidence in the long-term success of the American economy. The Conference Board's leading economic index, a comprehensive amalgamation of key economic indicators, has been signaling trouble for some time. This index is intended to signal a potential slowing of economic activity, prompting investor caution.
- Consumer sentiment has improved, but it might not last. In July, U.S. consumer sentiment rose to a nearly two-year high of 72.6 on the University of Michigan's index, up from June's 64.4 and surpassing expectations. This surge reflects easing inflation worries and a strong job market. One reason for caution? J.P. Morgan CEO Jamie Dimon recently warned that U.S. consumers may be using up their savings due to inflation, which he says could result in a 2024 recession.
- There are geopolitical threats that could destabilize markets, especially energy prices. The war in Ukraine continues to weigh on global markets, adding an unpredictable dimension to global energy markets. Despite earlier declines, gas prices have recently spiked by nearly 30 cents to reach a national average of $3.82. This increase has been driven by OPEC+ (a coalition of oil-producing countries, including Russia) implementing output cuts to boost crude prices. Saudi Arabia also recently decided to maintain its production cut in a bid to increase energy prices. We believe this is a medium-term risk to Western economies. As more renewable sources come online, coupled with the promise of newer technologies like nuclear fusion, dependency on coal, oil & natural gas will decline substantially.
Our take: Xillion maintained throughout 2022 that the U.S. market remained an attractive investment. We cautioned against giving into market panic by pulling out investments. That turned out to be great guidance. If you took your money out of the S&P 500 in June of 2022, you would miss a 20% increase in investments. The markets can tell optimistic or pessimistic stories depending on your perspective. But our product optimizes for long-term success, and that means trusting the long-term growth of American stocks.