So, will this trend hold up and lead to a soft landing? And what we expect this year?
When the tightening policy first began, the equity market suffered and the markets were pessimistic. The economy, however, proved resilient enough to avoid a recession in 2023, challenging expectations.
In a tightening policy environment with high rates, positive performance was recorded, as the GDP growth rate remaining above 3% over the last two quarters and the unemployment rate remaining low at 3.7%, while inflation sharply decreased from 9% to 3.35% in December of last year.
The economy's ability to resist the tightening policy can primarily be attributed to household spending that has been robust month after month, despite the high interest rates policy, which helped to sustain robust activity rates. Also, what truly boosted the economy was the Fed guidance about the possibility of a soft landing, which in turn boosted the stock markets.
As a consequence, we can mainly attribute the secret to maintaining a high household expenditure despite the tightening policy is higher wages and savings, as during the pandemic households accumulated an approximate 2.1tn, which explains why people’s spending hasn't really been affected by higher rates.
Thus, part of the reason why a recession has so far been avoided is that consumers have been able to shoulder higher prices because of higher wages and large sums of savings, indicating that people’s spending is mainly driven by income, and on top of that, a large proportion of outstanding consumers’ debt like mortgages and auto loans is locked into low rates at pre-pandemic levels, all of which mitigated the impact of interest rate hikes.
These robust macroeconomic variables, along with the Fed's guidance, have created an environment of optimism and high market sentiment. As a consequence of the positive monthly reports, the market became more data-dependent, and investors based their investment decisions on the performance of these reports.
However, high reliance on short-run data could be problematic, as any unfavourable data released may drive the market down, particularly in a data-dependent market. Also, we should bear in mind that the rise in the S&P 500 is primarily driven by the largest 7 companies, implying that not all firms are doing well.
It's also important to note that the significant decline in inflation is mainly attributed to the reopening of large economies and the ease of supply chain channels, along with a dramatic drop in energy prices.
Although the Fed predicted three rate cuts in 2024, markets are pricing four to five rate cuts beginning in March of this year due to high optimism. Unfortunately, due to the stubbornness of core PCE services ex-housing inflation, the Fed is unlikely to start a rate cut in March, and day after day, the market is losing part of its optimism, which explains why this upward trend may not be persistent and could even turn into pessimism if the upcoming data were not as expected, especially as we noticed that inflation spiked up again in December and January with more geopolitical tensions are spreading around.
The rigidity of the core PCE inflation is mainly related to higher labour costs, as the provision of these services is highly labour-dependent, and therefore, we can assume that wage growth is the main driver of prices in these components. These higher wages are leading to higher prices, and in turn, higher prices are leading to wage rises — a recurring cycle. This could explain why the Fed is waiting for the job market to cool down in order to start rate cuts. It is also crucial to know that the strong labour market conceals many underlying problems in terms of the way it is calculated.
Another factor making the Fed reluctant to start a rate cut very soon is the sharp drop in bond yields since last November, which reinforces financial ease — something that the Fed doesn’t want in the meantime, as it’s believed to be premature and may reignite inflation.
In response to higher than expected CPI inflation in January, the Fed announced that they are not expecting any rate cuts soon in March and that they are looking for a sustained decrease in monthly inflation rates to start cutting rates thereby, higher rates for longer are expected.
On the other hand, GCC countries have a relatively lower inflation rate, which suggests that our countries should look for a more flexible monetary policy away from the dollar.
A worrying sign is that, according to a report from the Federal Reserve Bank of San Francisco, household savings accumulated during the pandemic declined from a peak of $2.1tn to $430bn. This suggests that consumers' affordability is no longer as strong as it was and that we should expect lower purchasing power in the upcoming months, which in turn affects economic activity. Also, the banking sector is under increasing pressure from this phenomenon as a result of consumers using their credit card loans to fund their purchases during the last quarters.
Consequently, by the end of September, about 8% of credit card balances had defaulted, exceeding pre-pandemic levels for the first time. To put the magnitude of the problem into perspective, more than one-third of consumers have more credit card debt than cash reserves. This issue is arising at a time when the unrealised losses for the banking system reached around $700bn, accounting for 30% of all bank equities.
Putting this in perspective, even at the worst point during the financial crisis, unrealised losses did not exceed 5% of all bank equities. Moreover, the commercial real estate sector is also pressuring the financial system, particularly due to record-high vacancy rates in commercial real estate properties, exerting downward pressure on rental prices and property values.
This downward trend in the commercial real estate market is spiking delinquency rates, and smaller banks are more affected by this trend, as according to research from Apollo, small banks account for nearly 70% of all commercial real estate (CRE) loans outstanding, implying that small and medium banks have high exposure to commercial real estate sectors, unlike larger banks.
The New York Community Bancorp was one of the major banks impacted by this trend, and it is currently facing financial distress due to its high exposure to real estate loans. A report issued by Fitch concluded that if commercial real estate prices decline by 40% on average, losses in CRE portfolios could result in a decent number of banks going bankrupt. A concerning sign is that the delinquency rates are increasing while unrealised losses are at their peak and the bank-term funding programme is nearing an end, all of which threatens the ability of banks to remain solvent.
Implying that the threat of bankruptcies is not over yet and that high rates for longer may lead to a break in the financial system particularly between the small and medium sized banks. Another interesting sign to look at is the excess reserves of depository institutions, which have been increasing since July of last year, implying that there is a high level of uncertainty among investors and institutions, particularly when it comes to long-run investments, which is clearly reflected in the amount of buffer reserves held by the depository institution.
Even more, we can notice that mortgage demand fell to a new 30-year low in January as housing affordability continues to get worse and people wait for rate declines to make their buying decisions. Now, this trend explicitly shows how a recession may arise as people are continuing to delay their buying based on that, which explains why a higher rate for longer may threaten the idea of soft landing.
Despite the unfavourable inflation results in December and January, there are some essential factors that pressure the Fed to start cutting rates by the middle of this year. For the first time since 107 years ago, the Fed recorded a loss of around $114.3bn, mainly due to the significant hike in interest rates, which led to massive amounts being spent on interest payments on the Fed's liabilities.
Another important element driving the Fed to lower rates is political pressure; the Democrats' chances of winning this year's presidential election are weakened by high rates for extended periods of time, which increases the pressure to begin lowering rates.
Additionally, there is a strong incentive to begin rate reductions as soon as possible in order to minimise the impact of financial distress on firms and maintain the plan of a soft landing.
So, what might be the impact of cutting rates on the economy and the markets?
Cutting rates is welcome news that the market and investors are waiting for, as it would help stimulate the economy and mitigate some of the uncertainty caused by the tightening policy. Since the start of the hike in interest rates, the money market funds have witnessed a massive capital inflow as the total assets held went from $4.5tn to $6tn. Hence, with rate cutting, large portion of this massive capital is expected to leave the money market funds into the equity markets and other investments, all of which help in fostering the economy.
This also implies that; lower gold prices are expected as with lower rates part of the economic uncertainty will be diminished and other investment opportunities would be more attractive, all of which drives gold price down. However, the case will be totally different if a recession fails to be averted, as in this case, gold will be the top gainer.
Lowering rates could also be welcome news for IPOs, as many firms are adopting a wait-and-see approach, postponing their offerings until market conditions appear more favourable since the types of investors engaged in IPOs tend to use leverage in their investment decisions.
Hence, we may start seeing more IPOs if the economy proves to be resilient and rate cuts start. Although rate cuts may have a favourable effect on investment and expenditure levels, we should remember that there are still other significant difficulties that hinder growth, especially in the GCC, where we have observed a steep decrease in gas and oil prices, which is anticipated to be continued during the year as major economies are thought to be heading towards a recession like China, Japan, Germany and the UK, all of which drive other economies towards economic slowdown and pressure gas and oil prices, something that is unfavourable for Asian and GCC economies as oil and gas are regarded as the primary source of income in the region.
Speaking locally, we can notice that since the start of the US tightening policy in 2022, the Qatar Stock Exchange index has witnessed a dramatic drop of around 24%. In addition to that, we can also notice a remarkable decline in the real estate sector, as the number of trades conducted in 2023 fell by 21.2% compared to 2022, scoring its lowest over the past 11 years, all of which pressure rental and selling prices. On top of that, new building permits also experienced a remarkable decline in 2023, as the number of permits issued in 2023 was 7900 compared to 8892 permits in 2022, which accounts for a drop of 11.16%. This significant drop in one of the largest sectors in Qatar could be a worrying sign, as a drop in the real estate market drives other sectors into a downturn since the development of new premises encompasses a wide range of activities and services, thereby undermining other sectors.
The upcoming rate cuts this year could be a welcome sign for these markets, as they will help reduce the opportunity cost of capital leaving money market funds, which could help in reinforcing equity and real estate markets. On the other hand, we should still bear in mind the macroeconomic variables pressuring gas prices and the ongoing geopolitical tensions in the region, all of which hamper growth.
As a conclusion, despite the GDP growth rates and the remarkable decline in inflation, it is too early to announce a victory against inflation and the accomplishment of a soft landing, as there are still various worrying signs that are threatening the resilience of the financial system, along with geopolitical tensions going around, all of which make the 2024 economic outlook cloudier and ignite uncertainty.
