Interest rates

Why Raising Interest Rates Doesn’t Work (Yet) – ShareCafe

It was a volatile year. High inflation, along with high actual and expected interest rates, rattled equity, fixed income, commodity and real estate markets. According to the theory, high interest rates stifle economic activity, reduce demand and moderate consumer prices.

A confusing macroeconomic context

But so far, the reality does not match the theory. Recent data across the United States shows that jobs and retail sales are still quite robust. Australia also continued to benefit from record unemployment and strong retail sales. Additionally, recent earnings results have been better than expected with US earnings (S&P 500) up +6% in the US[1].

Source: St Louis Fred, Quay Global Investors

So what’s going on?

Of course, we know there is some economic lag in response to rising interest rates, and we also know that central banks are not yet at their “neutral rate”, but we think there there’s more to the story – especially between countries.

We believe the best framework for understanding the current environment is through sector balances – which we review below.

Sector balance sheets (summary)

Regular readers of Investment Insights will know that we believe that sector balances[2] are one of the best tools for understanding the macroeconomic environment.

In summary, for a country or region with a floating exchange rate:

In other words, one entity’s income is another’s expense. Moreover, one entity’s surplus is another’s deficit.

In the formula above, if one entity decides to save, it forces the other sectors (in total) to dissave. This is colloquially known as the “thrift paradox”.[3].

The following chart illustrates the US sector balance over time. Note that deficits and surpluses offset each quarter – to the nearest penny. The notion of sectoral balances is not an economic theory, it is simply old accounting.

Source: St Louis Fred, US Federal Reserve, Quay Global Investors

Household balance sheets are in very good shape

One reason the higher rates haven’t really taken a bite yet is that household balance sheets are in pretty good shape. COVID has seen governments around the world respond with extraordinary budget spending. Some more than others. According to sector balances, deficits (the United States was among the largest relative to GDP) resulted in savings to non-government sector bank accounts – particularly households.

The impact was deeper in the United States due to the scale of fiscal transfers (more than 25% of GDP). As a result, US household net financial debt (debt minus cash on deposit) has returned to 1996 levels. And as a percentage of GDP, to levels not seen since the late 1980s.

Source: St Louis Fred, US Federal Reserve, Quay Global Investors

Note that the graphs above may look inconsistent (y-axis), but the graph on the left simply accumulates the quarterly net flow of savings (excluding asset purchases), while the one on the right is net of asset purchases .

This raises two important points:

  • US households are far less sensitive to interest rate fluctuations than at any time in the past 25 years, especially since most US mortgages are fixed for 15 to 30 years.
  • The recession in household balance sheets that caused the GFC in 2007 is evident in hindsight, but it is also highly unlikely to recur in the current environment.

There are, of course, distributional effects to consider. Some households have a lot of debt and others have a lot of cash; but it has always been so. What has changed is that there is a lot more cash/deposits relative to debt than before, and this is clearly having an impact, especially given the accelerating growth in the number of pensioners who depend passive income for their consumption. If you hear a “cheer” every time the central bank raises interest rates, it’s probably coming from a retiree.

It’s also important that the United States has stood out when it comes to the COVID fiscal response. Tax transfers to other countries, in some cases, were significantly lower (especially in Europe). The United Kingdom, Australia, New Zealand and Japan received large tax transfers, although much lower than the United States.

In short, not all household balance sheets are the same, so rising interest rates will have varying impacts around the world.

Source: IMF, Quay Global Investors

High interest rates can contribute to growth and inflation

Traditional economic theory tells us that the transmission mechanism for interest rate policy is through the household sector. Specifically, higher interest rates slow housing (price and supply), which eventually translates into lower sentiment and consumption.

Commentators rarely talk about the revenue channel effect. In other words, higher interest rates benefit net depositors. And while US households still have a small amount of net debt (according to the chart above), it’s worth remembering that most US debt is fixed-term mortgages. Meanwhile, any accumulated cash can immediately benefit from higher interest income.

More generally, the entire non-governmental sector is a beneficiary of net interest income. How do we know? Because the US federal government has net debt and is therefore a net payer of interest income. Expenses of one entity are revenues of another (according to segment balances).

As the following chart shows, the US government currently pays $0.6 billion a year in interest on outstanding bonds (2% average rate). If interest rates double, another US$0.6,000,000 will flow to the non-government sector, increasing purchasing power and potentially worsening our inflationary woes.

Source: St Louis Fred, Quay Global Investors

Again, it is worth differentiating between countries. The indebtedness of Australian and New Zealand households is very short-term (variable loans and mortgages of two to three years). This means that these economies benefit less from the “revenue channel” of higher interest rates compared to the United States. Additionally, Australia’s federal debt/GDP levels are significantly lower than those of the US, so we won’t get the same fiscal transfers via high interest rates.

In summary, while Australia has historically been more sensitive to higher interest rates than the United States, the impact of the growing income channel effect means that the United States becomes, comparatively, even less sensitive.

This may have long term monetary implications for the USD-AUD.

Inflation is more about “distribution effects” than macroeconomic headwinds

Another mystery of the current macroeconomic environment is why consumers continue to resist despite high levels of inflation.

Here again, sectoral balances can be useful.

Higher prices via inflation are usually paid to the supplier – so that one person’s nominal (rising) expenditure equals another’s nominal (rising) income. If real wages fall, other things being equal, real profits rise. In this context, is it so surprising that second quarter US profits rose by +6% and that corporate margins were at their highest since 1950?[4] (despite headwinds from lower fiscal deficits)? These profits are then used to reinvest or pay dividends to households and other entities.

But what about the 1970s? High inflation was accompanied by low economic growth, and we experienced the dreaded “stagflation”. Here again, sectoral balances help.

If higher prices and inflation are driven by imports, net income accumulates for foreign savers (rather than domestic firms). According to sectoral balances, if the foreign sector is a net saver, revenues are drained from the domestic economy, causing a recession.

This dynamic played out in the 1970s during the oil crisis. At the time, the United States was a major importer of foreign oil (which represented a very large percentage of the economy). Inflation via rising oil prices benefits foreign suppliers, draining revenue from the domestic sector. A similar episode played out in 2007 (exacerbated by the financial crisis). Today, the United States is a net zero importer of oil and is therefore less prone to rising energy costs outside of normal distributional effects. So while the headline associated with rising commodity and energy prices sounds scary, the macro impact in the US is quite mild and very different from the 1970s or 2000s.

Of course, the beneficiaries of rising energy prices have been energy companies – the same companies that employ (mostly) local workers and pay dividends to (mostly) local investors. This is a good example of the redistributive effects of inflation (as opposed to a macroeconomic headwind); in this case redistributed to (very savvy) energy investors.

Source: FactSet

Final Thoughts

In November 2021, we published the article, Why the household savings boom won’t stop. In the final thoughts we wrote:

“This is not a normal cycle – few readers of this article (including ourselves) are fully equipped to understand the macroeconomic ramifications of such an incredible shift in politics and household financial health.”

The current macroeconomic environment seems to reflect this uncertainty. Again, this underpins our overall investment philosophy that macro investing is hard. We fundamentally believe that it is better to stick to more of certain long-term secular themes (eg demographic aging) supported by quality companies, strong balance sheets and specialized management teams.

In short, choose good stocks with reasonable valuations.

This remains our goal at Quay.

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[1] https://insight.factset.com/sp-500-earnings-season-update-july-29-2022#:~:text=The%20blended%20revenue%20growth%20rate,second%20quarter%20(juin%2030 ).
[2] https://gimms.org.uk/fact-sheets/sectoral-balances/
[3] https://www.investopedia.com/terms/p/paradox-of-thrift.asp#:~:text=The%20paradox%20of%20thrift%20is,levels%20during%20an%20economic%20recession

The content of this article represents the opinions of the authors. Authors may hold long or short positions in the securities of various companies discussed in the article. This commentary does not constitute a solicitation of business or investment advice. It is only intended to allow the authors to express their personal opinions on investing and to entertain the reader.