Paradox of high interest rates and a resilient economy

THE US’ booming stock market has brought much cheer to investors. From December 2019 to March 2024, the S&P 500 index saw a total US dollar return of 74 per cent, compared to 48 per cent and 16 per cent for Euro Stoxx 50 index (Europe) and MSCI Asia Pacific index (Asia), respectively.

The outperformance is a result of the US’ economic resilience and a higher representation of technology stocks. And despite the consensus view in early 2023 when some investors feared that an impending interest rate cut coupled with low unemployment rate would point to a late cycle, which is usually followed by a recession, the US economy has stayed healthy so far.

Why have higher interest rates failed to induce an economic slowdown?

Conventional economic theory posits that higher interest rates mean higher borrowing costs, which typically result in consumers channelling more income towards savings while businesses hold back investments. These factors would slow down economic growth.

However, this has not been the case when the Federal Reserve hiked interest rates aggressively since 2022. The economy even managed to grow by 3 per cent in 2023, a pace that is above trend. Notably, interest-rate sensitive sectors such as residential housing and automotive have not slowed materially.

There are several explanations for this economic resilience; the most cited one is that fiscal policy was exceptionally stimulative in 2023. At 6.5 per cent of gross domestic product, fiscal policy boosted the economy.

The second reason was accommodative financial conditions – or, put simply, obtaining money was easy. Despite higher interest rates, equity prices surged, and bank liquidity remained abundant. Record-high household wealth and a healthy labour market kept consumer spending brisk.

Counterintuitively, high interest rates stimulated consumption as much as it discouraged consumer debt. After years of near-zero interest rates, savings deposits earn attractive yields, which have reached levels comparable to investment-grade bonds. The total commercial bank deposits and money market fund assets in the US amounted to US$23.7 trillion as of March 2024, yielding a competitive return.

While interest rates have climbed precipitously, the US effective interest rate on mortgage debt outstanding remained modest at 3.8 per cent as at end-2023. Meanwhile, interest expenses of large US firms were mitigated by the deployment of hedges.

Finally, a resilient economy in the face of high interest rates suggests that the “neutral” rate could be higher than 2.5 per cent, a rate that the Fed has assumed even up to the recent Federal Open Market Committee meeting on Mar 21. If the actual neutral rate is, for instance, 3.5 per cent, it may suggest that the Fed’s policy stance may not be as tight as assumed.

Unfortunately, there is unlikely to be much clarity around this contentious issue. Further persistent economic resilience may lead the Fed to revise up its estimate based on “revealed preference”.

Is a productivity boom imminent?

The emergence of artificial intelligence (AI) is one of the most transformational developments in recent years. The speed of innovation and deployment is nothing short of exceptional. This has raised comparison with the 1990s, when then-Fed chairman Alan Greenspan, against the views of his colleagues, stayed his hand at raising interest rates.

Greenspan believed that a productivity boom was underway, driven by investments in computers even though there was scant evidence supporting that claim. This became one of Greenspan’s lasting legacies, as inflation remained stable and productivity growth proved to have contributed to the expanding economy then, although it only manifested in the data years later.

While there are challenges in confirming a productivity boom using current measures, there is corroborative evidence that one could be in the offing.

Is AI a productivity game changer or bubble in the making?

It has been a while since the Internet that a technology appears and becomes consequential and relevant for so many firms across all sectors overnight. The current boom has some resemblance to the late 1990s when technology, as game-changing as it was, witnessed a parabolic surge to bubble proportions.

However, there are some material differences. The first is that the current surge in some of the early AI plays, such as semiconductor company Nvidia, was due to a spectacular rise in earnings rather than the elusive hopes of future profitability. The Nasdaq 100 index, a technology-dominated index, currently trades at 26 times next year’s earnings, which is considerably lower than the peak of 75 times during the technology bubble in year 2000.

Secondly, the potential deployment is vast and will disrupt not only low-level processing work, but potentially also knowledge and creative work.

Detractors would argue that the so-called productivity gains are due to a huge influx of illegal immigrants, which understates the number of employed workers. While this is somewhat true, it does not negate the game-changing nature of AI’s applications.

Admittedly, measuring structural productivity gains is often fraught with difficulties given factors such as cyclical effects, quality adjustments and informal work arrangements.

Investing in the current environment

Monetary policy works with long and variable lags. Recent data suggest that the Fed may take longer to attain the 2 per cent inflation target, which implies that interest rates may stay elevated longer than originally expected.

However, various factors discussed above point to continued economic resilience and an extended cycle, rather than a complete reversal of the role of interest rates. The implication may be that investors will be encouraged to diversify from the “Magnificent 7” equities, into other broader-value cyclical exposures including energy, industrials and financials.

While bonds may not yield as much price gains from a rapid decline in interest rates, the total return profile will still be respectable. Moreover, an exposure to high-quality bonds will offer diversification against a sudden growth downturn.

Investors should also look outside the US to Japan, Asia, and parts of Europe for investment opportunities. These regions trade at less demanding valuations. Lastly, an allocation to alternative assets would further augment portfolio resilience as these assets do not move in tandem with traditional assets. The key to successful investing is to construct a quality portfolio that will be resilient under different macroeconomic scenarios.

The writer is chief investment officer at UOB Private Bank