Investment Strategy

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

Jul 19, 2022

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.

The Fed has launched its hiking cycle; the ECB will soon follow suit

Sources: Federal Reserve, European Central Bank, Bloomberg Finance L.P., J.P. Morgan Private Bank. Data as of June 30, 2022. Market expectations for the Fed are determined by Fed Fund futures. Market expectations for the ECB represent the 1-day ESTR (the 1-day interbank interest rate for the Eurozone). Expectations as of July 11, 2022.
This chart shows the Fed funds rate and ECB deposit rate from 2015 to 2022, and shows the expected rate hikes heading into 2024. In 2015, the Fed funds rate and ECB deposit rate were about .125% and (-.2%) respectively. In 2023, the Fed funds rate and ECB deposit rate are expected to rise to 3.5% and 1.0% respectively.

 

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.  

Home affordability has plummeted to 2006 levels

Source: National Association of Realtors/J.P. Morgan Private Bank as of May 2022.
This chart shows the Affordability Index and average new home sale price in the U.S. from 2004 to 2022. In January of 2004, the affordability index began at 124.65 and the average new home sale price was about $250,000. After rising to a series high of about 200 in 2012, the affordability index sits at 115 in 2022. With an average new home sale price of about $515,000, affordability in 2022 has dropped to 2006 levels.

 

For borrowers, 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. 

Glacier of negative yielding debt has melted away

Source: Bloomberg Finance L.P. Data as of June 30, 2022
This chart shows the share of the Bloomberg Global Agg index with negative yielding debt from 2014 to 2022. It began close to 0% then rose to 7.4% on December 2014 and 25.7% in June 2016. It fell to 12.8% in September 2018 before rising again to a series high of 29.8% in August 2019. It fell from here to 18.2% in March 2020 and 4.5% in April 2022.

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.  

During quantitative tightening, balance sheets may shrink

Source: Congressional Budget Office and Federal Reserve Survey of Primary dealers as of May 2022.
This chart shows the Fed balance sheet as a percentage of United States GDP from 1990 to 2022. It began close to 5% and then rose to 15% in 2008. It climbed to around 25% in 2014 before falling to 18% in 2019. From here, it rose to a series high of 37.9% in 2022. It is projected to fall at around 22.7% at the end of 2024.

 

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.

Fiscal support surged during COVID and is quickly fading

Source: Haver. Data as of May 2022.
This chart shows government transfers as a percentage of Americans’ personal income from 2011 to 2022. The percentage stays rather flat at around 17% from 2011 to 2019 before spiking to 31% in April of 2020. We see this percentage fall to around 18.9% in November of 2020 before jumping back up to 33.6% in 2021. At the end of May 2022, the percentage sits at 18.1%

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.

Contact us to discuss how we can help you experience the full possibility of your wealth.

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