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Five things investors have learned

this year
The economy and asset prices have proved more resilient than feared

1
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5.

image: rose wong

Aug 1st 2023 Share

S tockmarkets, the economist Paul Samuelson once quipped, have predicted nine
out of the last !ve recessions. Today they stand accused of crying wolf yet again.
Pessimism seized trading "oors around the world in 2022, as asset prices plunged,
consumers howled and recessions seemed all but inevitable. Yet so far Germany is the
only big economy to have actually experienced one—and a mild one at that. In a
growing number of countries, it is now easier to imagine a “soft landing”, in which
central bankers succeed in quelling in"ation without quashing growth. Markets,
accordingly, have spent months in party mode. Taking the summer lull as a chance to
re"ect on the year so far, here are some of the things investors have learned.

The Fed was serious…

Interest-rate expectations began the year in an odd place. The Federal Reserve had
spent the previous nine months tightening its monetary policy at the quickest pace
since the 1980s. And yet investors remained stubbornly unconvinced of the central
bank’s hawkishness. At the start of 2023, market prices implied that rates would peak
below 5% in the !rst half of the year, then the Fed would start cutting. The central
bank’s o#cials, in contrast, thought rates would !nish the year above 5% and that cuts
would not follow until 2024.

The o#cials eventually prevailed. By continuing to raise rates even during a miniature
banking crisis (see below), the Fed at last convinced investors it was serious about
curbing in"ation. The market now expects the Fed’s benchmark rate to !nish the year
at 5.4%, only marginally below the central bankers’ own median projection. That is a
big win for a central bank whose earlier, "at-footed reaction to rising prices had
damaged its credibility.

…yet borrowers are mostly weathering the storm

During the cheap-money years, the prospect of sharply higher borrowing costs
sometimes seemed like the abominable snowman: terrifying but hard to believe in.
The snowman’s arrival has thus been a double surprise. Higher interest rates have
proved all-too-real but not-so-scary.

Since the start of 2022, the average interest rate on an index of the riskiest (or “junk”)
debt owed by American !rms has risen from 4.4% to 8.1%. Few, though, have gone
broke. The default rate for high-yield borrowers has risen over the past 12 months, but
only to around 3%. That is much lower than in previous times of stress. After the
global !nancial crisis of 2007-09, for instance, the default rate rose above 14%.

This might just mean that the worst is yet to come. Many !rms are still running down
cash bu$ers built up during the pandemic and relying on dirt-cheap debt !xed before
rates started rising. Yet there is reason for hope. Interest-coverage ratios for junk
borrowers, which compare pro!ts to interest costs, are close to their healthiest level in
20 years. Rising rates might make life more di#cult for borrowers, but they have not
yet made it dangerous.

Not every bank failure means a return to 2008

In the panic-stricken weeks that followed the implosion of Silicon Valley Bank, a mid-
tier American lender, on March 10th, events started to feel horribly familiar. The
collapse was followed by runs on other regional banks (Signature Bank and First
Republic Bank also buckled) and, seemingly, by global contagion. Credit Suisse, a 167-
year-old Swiss investment bank, was forced into a shotgun marriage with its long-time
rival, ubs. At one point it looked as if Deutsche Bank, a German lender, was also
teetering.

Mercifully a full-blown !nancial crisis was averted. Since First Republic’s failure on
May 1st, no more banks have fallen. Stockmarkets shrugged o$ the damage within a
matter of weeks, although the kbw index of American banking shares is still down by
about 20% since the start of March. Fears of a long-lasting credit crunch have not come
true.

Yet this happy outcome was far from costless. America’s bank failures were stemmed
by a vast, improvised bail-out package from the Fed. One implication is that even mid-
sized lenders are now deemed “too big to fail”. This could encourage such banks to
indulge in reckless risk-taking, under the assumption that the central bank will patch
them up if it goes wrong. The forced takeover of Credit Suisse (on which ubs
shareholders were not given a vote) bypassed a painstakingly drawn-up “resolution”
plan detailing how regulators are supposed to deal with a failing bank. O#cials swear
by such rules in peacetime, then forswear them in a crisis. One of the oldest problems
in !nance still lacks a widely accepted solution.

Stock investors are betting big on big tech—again

Last year was a humbling time for investors in America’s tech giants. These !rms
began 2022 looking positively unassailable: just !ve !rms (Alphabet, Amazon, Apple,
Microsoft and Tesla) made up nearly a quarter of the value of the s&p 500 index. But
rising interest rates hobbled them. Over the course of the year the same !ve !rms fell
in value by 38%, while the rest of the index dropped by just 15%.

Now the behemoths are back. Joined by two others, Meta and Nvidia, the “magni!cent
seven” dominated America’s stockmarket returns in the !rst half of this year. Their
share prices soared so much that, by July, they accounted for more than 60% of the
value of the nasdaq 100 index, prompting Nasdaq to scale back their weights to
prevent the index from becoming top-heavy. This big tech boom re"ects investors’
enormous enthusiasm for arti!cial intelligence, and their more recent conviction that
the biggest !rms are best placed to capitalise on it.

An inverted yield curve does not spell immediate doom

The stockmarket rally means that it is now
bond investors who !nd themselves
predicting a recession that has yet to arrive.
Yields on long-dated bonds typically
exceed those on short-dated ones,
compensating longer-term lenders for the
greater risks they face. But since last
October, the yield curve has been
“inverted”: short-term rates have been
above long-term ones (see chart). This is
!nancial markets’ surest signal of
impending recession. The thinking is
roughly as follows. If short-term rates are
high, it is presumably because the Fed has
tightened monetary policy to slow the
economy and curb in"ation. And if long-
term rates are low, it suggests the Fed will
eventually succeed, inducing a recession
that will require it to cut interest rates in
the more distant future.

This inversion (measured by the di$erence

between ten-year and three-month Treasury yields) had only happened eight times
previously in the past 50 years. Each occasion was followed by recession. Sure enough,
when the latest inversion started in October, the s&p 500 reached a new low for the
year.

Since then, however, both the economy and the stockmarket have seemingly de!ed
gravity. That hardly makes it time to relax: something else may yet break before
in"ation has fallen enough for the Fed to start cutting rates. But there is also a growing
possibility that a seemingly foolproof indicator has mis!red. In a year of surprises,
that would be the best one of all. 7

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