Can the economy actually handle higher rates?

Headline inflation peaking, global economy on firm footing

Last time, I wrote that the dominant “narrative” taking hold among investors today is the notion that the global economy is on the edge of becoming unhinged – that the world faces a deep and imminent recession as central banks aggressively tighten monetary conditions to stanch inflation. Macro fault lines marble the entire globe, from tangled supply chains to soaring energy prices. The belief that a day of reckoning is at hand is very strong. Investors become hostage to a dominant narrative like this, but often, however, it turns out to be dead wrong.

When the consensus is this strong, investors should stay alert for new narratives that can rapidly change market direction. The risk of making bad investment decisions has exploded higher in the current environment.

At our recent webinar, we answered some of the key questions related to our theme. Here are two more.

Question: Will inflation accelerate or decelerate from here?

We have written extensively on the topic of inflation over the last year (see “Taming the hurricane”). But central bankers were caught flat-flooted, initially overplaying the supply side (bottlenecks and such) and underplaying the demand side (rising household wealth, stronger capital spending, and a structurally looser fiscal stance).

Still, some inflationary dynamics were always bound to be (whisper it) transitory. Lockdown-triggered bottleneck issues are now easing. The supply side is catching up and shortages are being resolved. In fact, rather than scarcity, overcapacity lies ahead for some sectors. That leaves energy prices as the key driver of the overall inflation outlook. Supply conditions remain extremely tight, amidst the Ukraine war shock and glaring lack of capital investment over the last decade. Yet some moderation in global growth will lower demand.

Adding it all up, energy prices are likely to stay elevated, but the rapid acceleration phase is behind us. And while inflation is a slow-moving variable, which should remain elevated for some time, headline inflation is peaking right now. That will take some pressure off central bank hawkishness and bolster risk appetite.

Question: Can the economy actually handle higher interest rates?

Monetary tightening is the leading cause of recessions. But at the risk of stating the obvious, interest rates are still insanely low relative to the growth and inflation backdrop. Real rates remain deeply negative. The Fed and the Bank of Canada are nowhere close to recession-inducing rates.

The real issue is that most investors are still anchored to the secular stagnation period after 2008 – most simply do not believe the economy can ever escape low interest rates. But in the 2010s, the need for consumers to repair balance sheets necessitated a far lower interest rate. An extended period of debt reduction, cleansing of excesses, and overall financial system repair was needed.

Today, we simply do not have the same economic and financial imbalances. The economy is actually on far firmer footing and several dynamics are different: a robust labour market; healthier consumer balance sheets; and a well-capitalized banking system. Interest rate hikes have landed on a white-hot economy, not one balanced on the edge of recession. The big surprise will be that the global economy can handle “higher rates for longer” without tipping into a deep and protracted recession.

Next time: Transitioning away from fossil fuels, best investment opportunities, and the outlook for cryptocurrency.

Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. The Forstrong Global Investment team contributed to this article. This article first appeared in Forstrong’s “2022 Super Trends: World in Transition” publication available on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

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