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Investing

It’s the end of easy money. 5 charts count the ways

Higher rates and tighter financial conditions create challenges for economies and asset markets. Here’s what you need to know.


 

The Federal Reserve’s campaign against inflation has been the key driver of global financial markets this year. Headline inflation, which touched a 40-year high, coupled with a tight labor market are pushing the Fed to aggressively tighten financial conditions.

Financial conditions broadly describe the economic environment for citizens and corporations. Tighter conditions mean consumers and corporations are less likely to borrow or invest, leading to a decline in future growth and inflation. Absent a recession, financial conditions never tightened as much in a six-month period as they have in the first half of 2022. It’s the end of COVID-19 easy money.

We see this new dynamic in three key areas—rates, liquidity and fiscal policy, as these five charts make clear.

Rates: An aggressive path to higher rates and yields

Central banks globally are charting aggressive hiking paths. The market anticipates that the Fed will hike the federal funds (policy) rate to ~ 3.5% by the first quarter of 2023. This would be the speediest hiking cycle since the mid-1990s, bringing the policy rate to its highest level in over a decade.

What’s more, the market expects the Fed to keep the fed funds rate near 3% for a decade.

The European Central Bank (ECB) is also expected to have positive interest rates—for the first time in a decade. 

While the Fed has only just started raising rates, Americans are already feeling the effects of expected hikes:

  • The 30-year fixed-rate mortgage has surged to nearly 6%, from just 3% at the start of the year.   
  • Monthly principal and interest payments on a 30-year fixed USD mortgage on a $510,000 home (the latest average price) jumped from ~$1,200 to $1,850.
  • The combination of higher mortgage rates and still-high home prices means that U.S. home affordability has plummeted to 2006 levels.

For corporations, the cost of financing has soared. Just last year, there was over USD 18 trillion of negative yielding debt globally. That glacier has melted to just USD 2 trillion today. 

Liquidity: Central bank balance sheets are shrinking 

During the era of easy money, central bank balance sheets ballooned—first in the wake of the global financial crisis and more recently in response to COVID-19. The Fed’s balance sheet swelled from USD ~4 trillion pre-COVID-19 to USD ~9 trillion today, as the Fed bought Treasuries and agency mortgage-backed securities. This added abundant liquidity to the financial system, pushing up asset prices.

Now, in a process known as quantitative tightening (QT), balance sheets may shrink and liquidity in the financial system will decline.

Market participants expect the Fed’s balance sheet to shrink to under USD 7 trillion by 2025, pushing the size of the balance sheet, relative to GDP, back to pre-COVID-19 levels.  

In Europe, QT will mean that the ECB stops buying corporate bonds. That change is imminent, and its impact could be significant. Currently, the ECB owns roughly one-third of the eligible corporate bond universe.

Fiscal policy: Diminished government support, lower savings rates

Across the world, governments have offered a range of fiscal support to mitigate the impact of the pandemic. European countries such as Italy and Germany have introduced spending measures to shield consumers from the full impact of higher energy prices. 

In the United States, fiscal support was the most pronounced. At the peak of COVID-19 fiscal stimulus, over one-third of American personal income came from transfers from the U.S. government.

As that support is disappearing, Americans are quickly spending down their excess savings. This could impact overall consumer spending and thus economic growth.

Investment implications  

How can you think about the end of easy money as it relates to your portfolio and family goals?

With the rate hiking cycle underway, yields have already moved higher—much higher in some cases. Higher yields can make for a good entry point to build a position in core fixed income, which still should offer a valuable ballast to portfolios. And if recession fears intensify, bond yields would likely fall, boosting total returns for existing bond portfolios.

As the end of easy money ushers in a period of sluggish economic growth, company margins and earnings will likely come under pressure. In this environment, quality companies (with fortress balance sheets and steady cash flow streams) should provide more consistent and reliable earnings growth. In our view, quality equities should outperform.

We can help

As you think about the implications of the end of easy money, your risk tolerance and investment goals should inform your decision making. Your J.P. Morgan team can help design a portfolio aimed for your financial goals.

 

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