Two lessons for the global economy, from the Fed’s 2007 missteps
- The US central bank is expected to maintain higher interest rates for longer, not unlike in the months leading up to the global financial crisis
- The trouble is that monetary policy eventually works and central banks can’t really control how that plays out
The earlier period of rate stability lasted 15 months and the expectation today is for the rate peak to last around 10 months. This plateau is being referred to in some quarters as a “Table Mountain”, after South Africa’s famous flat-topped peak.
Globally, things have become a little different since 2006-2007. China was in full growth mode at that time, with economic expansion of between 12 and 14 per cent. But the dollar was strong, like it is now.
So how did markets perform during that earlier period of “higher for longer” interest rates?
The good news is that everything delivered positive returns, though there was much dispersion. The Japanese equity market was the worst-performing stock index, managing only a 4.5 per cent change in 2006-2007, while emerging markets posted huge returns. China’s equity markets gained 200 per cent in the same time span.
This, in turn, had a positive impact on returns in markets like Mexico, Brazil, Hong Kong, South Korea and Japan. Germany was the best-performing Western equity market – even though European interest rates were rising – reflecting the impact of Chinese demand on German-manufactured goods such as cars.
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The core US and European markets did reasonably well. Both the S&P 500 and the Euro Stoxx rose around 20 per cent – perhaps concerns about recession were not as prevalent back then.
European government bonds, including British gilts, posted positive returns; yields were in the 4-5 per cent range and most of the returns came from income.
The International Monetary Fund’s September 2006 World Economic Outlook forecast the US economy to grow by 3.4 per cent in 2006 and 2.9 per cent in 2007, and the euro zone by 2.4 per cent and 2.0 per cent respectively. China’s growth rate was forecast at 10 per cent.
US Fed must watch its step as recession risks loom
What lessons can we learn from that period? We don’t know how long rates will stay at the peak or, indeed, if this is the peak. But the central scenario is that they do stay on hold, until data suggests the economy is weakening and inflation is back under control.
So a negative outcome of this cycle cannot be ruled out. There is potentially a period ahead when risk assets will significantly underperform.
There are rhymes in history. With short rates high and yield curves inverted, it is hard for longer-dated bonds to deliver much more than their yield.
For equity markets, the growth outlook is weaker now than it was then. China is stuttering, leaving the world with one less key driver of equity performance compared to the mid-2000s, when globalisation had not fallen out of favour. The prolonged period of high rates in 2006-2007 came after a two-year period of tightening by the Fed. But equity returns were generally positive.
This time, with a similar interest rate backdrop but weaker growth, it may be harder for the core equity markets to deliver 20 per cent returns.
Interestingly, since the Fed increased the rate to 5.25-5.50 per cent on July 26, global equities have delivered negative returns of more than 6 per cent. This is a different path to that seen in 2006. Leveraged growth was a popular idea back then, but not so much today.
The second lesson is that monetary policy eventually works and central banks can’t really control how that plays out.
Monetary tightening hit the US housing market and then the financial system in 2007 and its impact worsened in 2008. It ultimately led to a sharp drop in US growth in 2009. Inflation collapsed, turning negative, and the country’s unemployment rate shot up to 10 per cent. The Fed had to cut rates aggressively in 2008, to 0.25 per cent, where they stayed until the end of 2015.
If the Fed’s current monetary cycle follows a similar pattern and rates stay on hold until mid-2024, the long-threatened recession could come in late 2024 or early 2025, with risk assets going through a significant period of underperformance and long-duration bonds delivering above-trend returns. This could be the last visit to Table Mountain for the global economy, for now at least.
Chris Iggo is chair of AXA Investment Managers Investment Institute and chief investment officer of AXA IM Core
