The year 2023 has been a whirlwind for the global economy, and the US economy has been at the center of attention. Amid widespread predictions of an impending recession, the US economy has exhibited unexpected resilience, leaving experts scratching their heads. As the CEO of Advanced Wealth Management, I sought to explore the factors driving this surprising turnaround. In this blog, I will delve into the concept of “long and variable” lag in monetary policy’s effect, as well as the evolving debt dynamics of households and corporations. Understanding these elements will help us make more informed decisions in the ever-changing economic landscape.
The Resilient US Economy
At the beginning of 2023, the prevailing view among economists, including myself, was that a recession was looming. However, the US economy surprised us all by displaying signs of acceleration. Factors such as a robust economy, strong equity performance, and tightening credit spreads bolstered the belief that the economy was experiencing a soft landing. Despite these positive indicators, caution is necessary, as we must remain vigilant about the path ahead and avoid complacency.
The “Long and Variable” Lag
To comprehend the economy’s subdued response to the substantial 525-basis point increase in fed funds rates over a mere 18 months, we can turn to economist Milton Friedman’s theory of “long and variable” lag in monetary policy’s effect. According to this concept, the impact of monetary policy changes may take longer to materialize than initially expected. This phenomenon may explain why the economy is not reacting as strongly to the recent hiking cycle.
Evolving Debt Dynamics
Beyond the “long and variable” lag, it is crucial to examine the debt dynamics of both households and corporations to gain further insights into the economy’s resilience.
Households have taken significant steps to reduce their leverage. As of 2021, approximately 42% of owner-occupied houses had no mortgages at all. Furthermore, about 75% of mortgage holders carry 30-year fixed mortgages with interest rates below 4%. These factors have rendered many borrowers less sensitive to interest rate changes, leading to a more muted response to rate hikes.
Similarly, corporations have made use of historically low interest rates during the COVID period to build precautionary cash reserves. This has resulted in record-high cash percentages of liabilities on corporate balance sheets. Additionally, the duration of the Bloomberg US Aggregate Bond Index has reached an all-time high, indicating that corporations are actively managing interest rate risks.
Implications for Asset Allocation
Given the potential for a lengthier lag in the impact of monetary policy and the uncertainties in the economic landscape, investors must adapt their asset allocation strategies. Traditional approaches, like the 60/40 portfolio, may not provide optimal returns and risk management in this dynamic environment. Instead, we must consider more innovative and forward-looking approaches to asset allocation.
As the CEO of Advanced Wealth Management, I believe that these uncertain times present opportunities for creative and conviction-based investing. Dislocations in the market can be viewed as chances for capital deployment, rather than sources of fear. Exploring private market alternatives can offer compelling diversification opportunities and help navigate changing economic conditions.
Conclusion
The resilience of the US economy in 2023 has defied expectations and sparked discussions about the efficacy of monetary policy. By understanding the “long and variable” lag and analyzing the evolving debt dynamics, we can gain valuable insights into the economy’s behavior. As we move forward, let us remain vigilant and adapt our investment strategies to the ever-changing economic landscape, securing our financial future with prudence and foresight.
References:
1. Friedman, M. (1961). “The Lag in Effect of Monetary Policy.”
2. Data Source: eMBS, Fannie Mae, Goldman Sachs Global Investment Research, as of 7/11/2023. PMMS represents Fannie Mae’s Primary Mortgage Market Survey.
3. Data Source: Bloomberg, as of 7/24/2023.
DISCLOSURE-Please note that this commentary is intended solely for the purpose of providing general information. It should not be interpreted as advice on investments, taxes, or legal matters and does not establish an attorney-client relationship. The past performance of any market is not indicative of future results. While the information presented here is sourced from reliable outlets, it is not guaranteed.