The US economy has been surprisingly resilient despite 525 basis points of Fed rate hikes over the last two years.1
In our view, the two main reasons for the resilience were: 1) limited interest rate sensitivity thanks to households and businesses locking in low interest rates on their debt especially after the Fed had pushed down long-term interest rates during COVID and 2) massive fiscal stimulus over the last four years.
The economy has defied recession, but it has not become invincible. We expect that the conditions that sustained growth will fade and that is likely to reveal cracks in the vulnerable parts of the economy. The Fed may ease policy later this year, yet households and businesses still must adjust to higher interest rates, while the super loose fiscal policy stance is unlikely to be sustained for much longer.
On the other hand, the economy is not sick, and we believe that improving global growth conditions will support growth in the US as well. We also observe promising signs of structural change that may raise US productivity over time.
After a sluggish performance in 2022, most forecasters expected that the US economy would enter recession in 2023, although not a deep one (see Table 1). Unemployment was also predicted to rise and that was expected to bring down inflation. The Fed did not predict outright recession but was looking for a weak economy as well.2
Source: Blue-Chip Consensus Forecasts, Board of Governors of the Federal Reserve System, Bureau of Economic Analysis and Bureau of Labor Statistics3
The actual outcome beat expectations in two ways.
First, the economy avoided recession and even accelerated notably, while unemployment stayed low.
Second, inflation declined nevertheless (see Table 1 again). Housing activity had already contracted in 2022 when interest rates started to rise and stayed weak in 2023, but consumption made an impressive rebound and investment growth stayed firm, while government spending accelerated (see Table 1 again).
To be sure, other major economies with similar rate hikes, notably in Europe, managed to dodge recession as well, and also succeeded in taming inflation, but their growth performance has been poor compared to the US.4
Higher interest rates impact the economy by tightening financial conditions for businesses and households. The result is typically declining business investment, less housing activity and reduced household consumption as higher interest payments crowd out other spending. Depending on the degree and structure of indebtedness, the financial tightening can also result in financial stress and trigger a wave of foreclosures and defaults as during the financial crisis.
In this tightening cycle, we have seen housing affordability and activity plunge rapidly soon after the Fed started to raise interest rates.5 However, the rise in interest rates did not have an adverse effect on overall household debt-service payments as had been the case in past cycles (see Chart 1, debt-service payments as a share of disposable income are still below pre-COVID levels).
Source: Board of Governors of the Federal Reserve System.6 Note that the drop in debt-service payments in % of disposable income and the subsequent rebound between 2020 and 2021 were due to the temporary surge in disposable income caused by the large government transfer payments7
The reasons for the low level of debt-service payments are two-fold. First, households have reduced the overall debt-load by more than a quarter since the financial crisis.8 Second, most homeowners had locked in long-term mortgages before the Fed started to tighten policy. As a result, the effective interest rate that homeowners pay on their existing mortgage has increased only marginally despite the surge in new mortgage rates (see Chart 2).9
Source: Bureau of Economic Analysis and Freddie Mac10
Businesses have on balance even benefited from rising interest rates. In contrast to past cycles, net interest payments have declined sharply in the course of COVID and through the period of Fed tightening (see Chart 3).
Source: Bureau of Economic Analysis11
This suggests to us that businesses have benefitted from Fed policy twice, first by locking in very low funding rates during COVID and second by earning more interest on their cash assets as the Fed tightened.
More broadly, the aggressive Fed rate hikes and banks’ tightening of lending standards to levels typically associated with recessions12 have failed to trigger financial stress. In fact, after some initial tightening, financial conditions even improved to levels normally seen in expansion periods (see Chart 4).
Source: Federal Reserve Banks of Chicago, Kansas City and St. Louis13
One reason is clearly that the rise in interest rates has not inflicted wide-spread balance-sheet problems for businesses and households as discussed above. The other reason, in our view, is the absence of major imbalances such as debt and asset bubbles and the improved banking-sector health.14
While monetary tightening was not hurting the economy as much as feared, fiscal policy was stimulating more than expected. Chart 5 (on the next page) shows the inverse relationship between the unemployment rate and the primary budget balance15 (rising unemployment corresponds to an eroding primary balance and vice versa) and highlights the extent of fiscal pump priming.
Source: Office of Management and Budget and Bureau of Labor Statistics16
For the last few years, the primary budget balance has been much worse than what would have been consistent with the movements of the unemployment rate. In fact, the current low rate of unemployment would normally imply a primary budget surplus (see Chart 5 again).
Source: Office of Management and Budget and Bureau of Labor Statistics and ZAIS own calculations17
Chart 6 shows the cyclical component of the federal primary budget balance derived from the unemployment rate and the excess primary budget balance that is not driven by the cyclical state of the economy. The latter deteriorated before the pandemic and despite some post-COVID recovery remains on a negative trajectory. The excess primary fiscal deficit stood still at 6.7% of GDP at the end of 2023 and over the last 4 years accumulated a total of 33% of GDP (see Chart 6 again).
During the pandemic, the fiscal stimulus was targeted directly at households and businesses in the form of transfers and subsidies (see Table 2). Even in 2023, the level of these payments had not completely reversed to the pre-COVID levels. Last year, the fiscal stimulus was mostly directed at government consumption and investment spending (see Table 2 again). In our view, the fiscal stimulus during COVID not only safeguarded the economy through the pandemic but also cushioned it versus the impact of the subsequent Fed tightening.
Source: Board of Governors of the Federal Reserve, Bureau of Economic Analysis18
On the business side, this effect is most visible in profits. Profit margins typically fall before recessions and only start to rise again when the economy recovers. During COVID, however, profit margins jumped to new highs and eased only moderately afterwards (see Chart 7).
Source: Bureau of Economic Analysis19
In our view, the strength of profit margins reflects in parts the health of the corporate sector.
However, we think that the jump of profit margins to record highs during COVID and the following resilience are largely due to three special factors.
Note that prices rose less than labor costs at the start of COVID but that was more than offset by fiscal subsidies.
Source: Bureau of Economic Analysis
23
With firms able to maintain high profit margins there was little pressure to cut employment and investment.
In fact, businesses were looking to hire more people than were unemployed.24 Investment growth remained firm25 and fiscal incentives under the Chips & Science Act as well as the Inflation Reduction Act have boosted investment in areas like manufacturing construction by close to 100% in 2023 (see Chart 9)
Source: Bureau of Economic Analysis26
Fiscal pump priming during COVID, limited interest-rate sensitivity and solid job growth were the main factors that supported the household sector and kept consumption going.
With consumer spending accounting for roughly 70% of total GDP, this was key for maintaining overall growth and greasing the cycle of mutually supportive business investment and hiring as well as household spending.27
Especially the large fiscal transfers during COVID, which households were not able and willing to spend immediately, have created large excess savings that helped cushion the impact of rising interest rates and inflation trough 2023 (see Chart 10).
Source: Bureau of Economic Analysis28
The decline of inflation in 2023 was also helpful, which pushed up real compensation per employee and together with solid job growth raised overall purchasing power (see Chart 11).
Source: Bureau of Labor Statistics and Bureau of Economic Analysis29
The reason for the Fed tightening was to bring down inflation. As the consensus forecasts as well as the Fed’s own predictions implied, that was expected to require an economic downturn and a rise in unemployment.30 As it turns out, the economy accelerated, unemployment stayed stable and yet inflation still came down.31 We see two factors that help explain the perceived puzzle.
First, most of the inflation decline from the peak in mid-2022 was driven by the goods sector (see Chart 12).
Source: Bureau of Economic Analysis32
In our view, that was primarily driven by the normalization in global supply chains and the decline in energy prices after the surge triggered by the attack of Russia on the Ukraine in early 2022 and not Fed tightening.
Second, there has been no wage-price spiral.33 We attribute that to the Fed’s success in keeping inflation-expectations anchored34 and the renewed influx of migrants which raised the prime-age labor force participation rate and prevented further wage growth increases (see Chart 13).
Source: Bureau of Labor Statistics35
All in all, we believe that the economy’s resilience reflects largely favorable policy conditions and prudent balance sheet management by households and businesses and is not a paradigm change. The economy has not become invincible and we expect that the favorable conditions that supported growth over the last two years will fade.
First, the Fed may cut interest rates later this year but we think monetary conditions will stay tight. As we argued in the prior ZAIS Insight “The Inflation Trap”, inflation may not fall sustainably to the 2% target, limiting the room for future interest rate cuts.36 On the other hand, real interest rates, which were deeply negative when inflation was running hot in 2021-22, only turned positive last year and are now reaching levels last seen before the financial crisis (see Chart 14).
Source: Board of Governors of the Federal Reserve, Bureau of Economic Analysis and University of Michigan37
Thus, after more than a decade of mostly negative real interest rates, businesses and households will have to adjust to positive real interest rates. Already, there are signs of financial stress on the edges. Refinancing conditions for leveraged loans and office real-estate debt have deteriorated and that has lifted default rates (see Chart 15 on next page). Delinquency rates for credit card debt and auto loans are also rising (see Chart 16 on next page). We expect that defaults and credit bifurcation will rise further as the impact of higher interest rates trickles through the economy.
Source: Pitchbook LCD and TREPP38
Source: Federal Reserve Bank of New York39
The other adjustment that may not come immediately but seems inevitable to us concerns fiscal policy. The latest budget outlook of the Congressional Budget Office makes a grim reading projecting an uninterrupted rise in the debt-GDP ratio as net interest outlays as a share of GDP rise to new historical highs.40
In our view, this will increasingly limit the room for discretionary spending or force some form of tax increases.
The economy’s surprising resilience has been a humbling experience for many economists. To us, a key lesson is that basic economic principles have not been nullified but that they may play out differently than in the past due to changing circumstances.
Looking ahead, we expect that Fed tightening will have a longer lagged effect than in the past, while fiscal support will fade. However, we also see positive factors that may support growth for going forward.
First, while the factors behind the resilience are likely to fade, that does not have to push the economy immediately into recession in our view. Profit margins come from very high levels and household debt payments are low by past standards and we think that it will take a while until they deteriorate to levels at which recession becomes inevitable.
Second, there are more encouraging signs that the global economy starts to recover as the disruptive impact of high inflation and energy prices fades.41
Third, eye-catching to us is the rise in US new business applications (see Chart 17). This was triggered by COVID but has endured and, in our view, is more than a stopgap measure for people who lost their jobs.
Importantly, high-propensity new business applications, which are firms that either already employ people or are expected to hire employees, have risen as well and account for roughly a third of all new business applications.42
Source: US Census43
The large share of new business applications in sectors like retail and professional services suggests that many new businesses have moved closer to residential areas where more people work from home (see Chart 18).44
Source: US Census45
This relocation effect will probably fade over time, but the rise in new business applications could still mark a shift to greater mobility in the economy, which combined with the rise and application of new technologies like artificial intelligence could lead to overall stronger productivity growth.
The list of possible positives and negatives for the US economic outlook is longer than the points we have listed here. We draw some firm conclusions, like the lagged impact of higher interest rates on households and businesses. However, we believe that the balance of all factors does not point strongly in a particular direction for the economy, while uncertainties remain high. Thus, it seems appropriate to us at this point to be more agnostic about the state and prospect of the economy.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
The information presented herein has been prepared and provided by and is confidential and proprietary to ZAIS Group, LLC, ZAIS Group (UK) Limited and their affiliates and subsidiaries (collectively, “ZAIS”). Accordingly, this material is not to be reproduced in whole or in part or used for any purpose except as authorized by ZAIS, is to be treated as strictly confidential and is not to be disclosed directly or indirectly to any party other than the recipient. By accepting receipt of this document, the recipient agrees to comply with this restriction and confirms its understanding of the limitations set forth in these disclaimers.
Unless otherwise noted, the source of information for the charts, graphs, and other materials contained herein is ZAIS. The charts, tables, and graphs contained in this document are not intended to be used to assist the reader in determining which securities to buy or sell or when to buy or sell securities. Additional information is available upon request.
This information has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy which may or may not be made available. Any such offer of securities would, if made, be made pursuant to definitive final private offering documents, which would contain material information not contained herein (including certain risks) or material that differs from the information contained herein and to which current and prospective investors are referred. Any decision to invest should be made solely in reliance upon such private offering documents. In the event of any such offering, this information shall be deemed superseded, amended and supplemented in its entirety by such private offering documents. Information contained herein does not purport to be complete and is subject to the same qualifications and assumptions, and should be considered by investors only in the light of the same warnings, lack of assurances and representations and other precautionary matters, as disclosed in an applicable private offering memorandum and subscription agreement. No representation or warranty can be given with respect to the terms of any offer of securities conforming to the terms hereof. There is no guarantee that the strategies set forth herein will be successful. The information should only be considered current as at the date specified herein and is subject to change at any time and without notice. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
Certain information contained herein represents ZAIS's current reasonable opinion and is based on unaudited and forecast figures which have been derived from multiple sources and have not been subject to specific due diligence. The information has been provided in good faith but is not guaranteed and is subject to uncertainties beyond ZAIS's control and should not be relied upon for the purposes of any investment decision. ZAIS makes no representations or warranties and accepts no liability whether in contract, tort or otherwise for (1) the information not being full and complete, (2) the accuracy of any opinion, (3) the basis on which any comparison has been drawn or the facts selected to make such comparison and (4) the assumptions underlying any opinions. ZAIS does not undertake to update its opinions. No opinion of this nature can be, and this information does not purport to be, full, complete, comprehensive or to contain all relevant information. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
These materials may contain statements that are not purely historical in nature but are “forward-looking statements”. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should” and “would” or the negative of these terms or other comparable terminology. These forward-looking statements include, among other things, projections, forecasts, estimates or hypothetical calculations with respect to income, yield or return, future performance targets, sample or pro forma portfolio structures or portfolio composition, scenario analysis, specific investment strategies or proposed or pro forma levels of diversification or sector investment. These forward-looking statements are based upon certain assumptions, some of which are described herein. Prospective investors are cautioned not to place undue reliance on such statements. No representation is made by ZAIS as to the accuracy, validity or relevance of any such forward-looking statement and the recipient agrees it is solely responsible for gathering its own information and undertaking its own projections, forecasts, estimates and hypothetical calculations. Actual events are difficult to predict, are beyond ZAIS’s control, and may substantially differ from those assumed. All forward-looking statements included herein are based on information available on the date hereof or such date specified and ZAIS does not assume any duty to update any forward-looking statement contained herein. Some important factors which could cause actual results to differ materially from those in any forward-looking statements include, among others, the actual composition of the investment portfolio, any defaults to the investments, the timing of any defaults and subsequent recoveries, changes in interest rates, changes in currency rates and any weakening of the specific obligations included in the portfolio. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower or higher than those presented. The value of any investment, and the income from it, may fall as well as rise. Accordingly, there can be no assurances that an investor will receive back all or any of the original capital invested. Further, the eligible investments may be leveraged and the portfolio of eligible investments may lack diversification thereby increasing the risk of loss.
ZAIS Group (UK) Limited is a company registered in England with number 08908933 and whose registered office is c/o Dixon Wilson, 22 Chancery Lane, London WC2A 1LS, United Kingdom. ZAIS Group (UK) Limited is an appointed representative of Infinity Asset Management LLP, which is authorized and regulated by the Financial Conduct Authority in the United Kingdom. ZAIS Group (UK) Limited’s status as an appointed representative of Infinity Asset Management LLP does not imply a certain level of skill or training. Investors will not benefit from the rules and regulations made under the Financial Services and Markets Act 2000 for the protection of investors, nor from the Financial Services Compensation Scheme in the United Kingdom. Nothing herein excludes any liability which ZAIS is not permitted to exclude by applicable law.
ZAIS Group, LLC’s registrations with the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”), and ZAIS Group (UK) Limited’s status as an appointed representative of Infinity Asset Management LLP (which is authorized by the United Kingdom’s Financial Conduct Authority (“FCA”), does not imply a certain level of skill or training.