By Nedgroup Investments and Truffle Asset Management

Why Being Defensive Is Still the Right Call

Despite the fastest rate hiking cycle in four decades, the US economy has managed to withstand rate pressure and remain resilient. While the Federal Reserve has signalled that the fight against inflation is not over and interest rates will remain higher for longer, market expectations of a “soft landing” for the US economy have grown.

Why has the US remained resilient?

The U.S. labour market has remained strong, with annualised wage growth in 2023 of approximately 4.5%. This is well above the US Fed's 2% inflation target. A buoyant labour market and excess household savings generated over the pandemic period have supported strong US consumption, as illustrated in the chart below. Real consumption is now back to the long-term average trend but still above real disposable income as consumer savings generated over the pandemic are yet to fully deplete.

Source: Federal Reserve Bank of NY, October 2023. The average trend for consumption and disposable income is based on growth from 2014 to 2019. Index is set at 100 in 2019.

The resilience of US consumers can also be attributed to mortgages being locked in at historically low rates. Roughly 60% of U.S. mortgage holders are paying fixed interest rates around 4%, compared to the current level of mortgage rates at around 8%. Given US mortgages account for a significant portion of US household debt, a large portion of the population is therefore protected from rising interest payments on their home loans. 

Source: Bloomberg

U.S. Corporates also have substantial amounts of debt that are on fixed payment terms.  The pressure from higher rates will start to bite as corporate borrowers need to refinance their debt over the next two years. There has been a shortening of outstanding terms in the high yield debt market as borrowers delay refinancing in the hope that rates will decrease. In the event of a recession, credit spreads which have remained relatively subdued could also expand, further increasing refinancing costs. Tighter lending standards are already evident and commercial loan growth has gone negative this year for the first time in 50 years (other than over the Global Financial Crisis (GFC)).  Significant falls in commercial loan growth are typically associated with a recession.

Source: RMB Morgan Stanley

Cracks are forming

Recessions are difficult to forecast and usually become apparent after the fact when historic measures of economic activity are released. However, signs of vulnerability are emerging in the US. High-frequency data reveals growing stress on US consumers. Credit card delinquencies, auto loan delinquencies, and corporate insolvencies are slowing rising. Notably, credit card delinquencies in the below 35 years age group have reached levels reminiscent of the GFC, indicating the younger age demographic is beginning to take strain. In regions where consumers lack mortgage rate protection, such as the UK and parts of Europe, this pressure is even more evident. From a business perspective, the mounting cost of financing is also slowly impacting the strength of corporate balance sheets, particularly for leveraged companies.

Source: New York Fed Consumer Credit Panel/Equifax

US valuations are elevated

Post the GFC, real interest rates fell dramatically and unsurprisingly the US market rerated from an average PE of around 14x to almost 17x. With real yields in the US now back to historic levels of more than 2%, the current PE of circa 18x appears overly high. Current market valuations imply real prospective returns of slightly more than 3% and with a real return of 2.2% from US bonds, there is a low margin of safety (or premium for risk) when investing in US shares.