To The Moon

Just when the market has finally embraced the concept of a soft landing, investors are finding out that there are also drawbacks to a soft landing. Compared to the doomsday image of stagflation less than a year ago, a soft landing may revive the fairy tale of Goldilocks, but that does not mean it is all rosy. Both in terms of liquidity, economics and valuation, there is something to be said for such a soft landing.

For central banks, the downside of a soft landing is that it is not clear whether inflation has finally returned to the 2 per cent target. The Russian invasion of Ukraine temporarily boosted inflation, but now inflation is benefiting from base effects a year ago. As a result, it was relatively easy to predict that 2023 would be the year of disinflation. It is only difficult to determine whether inflation will remain at 2 per cent after these transitory base effects, or still move a bit higher over time, say between 3 and 5 per cent. For this, central banks no longer look exclusively at inflation developments, but also explicitly at the labour market. Although this is weakening, the process is gradual and there is a reasonable structural labour shortage. This means that central banks will have to keep interest rates high for even longer, which is obviously not good news.

Two weeks ago, the bond market also seemed to abandon the near-term recession scenario, as witnessed by rising long-term yields. Although this was linked to Fitch's downgrade for the United States, apart from the timing, such a downgrade had been on the cards for some time. More than a decade ago, Standard & Poor's decided to downgrade the US rating from AAA to AA+ for much the same reasons (credit ceiling, political infighting). Of the big three, only Moody's still maintains a AAA credit rating. This reduces the number of AAA-rated countries to nine.

In a world where there is a strong need for risk-free capital, this seems a problem, but US Treasuries are seen as risk-free paper despite the AA+ rating. In fact, not much changes. The US government can always repay its debt down to the last cent, as it has the ability to print additional money without limit. That obviously affects inflation, but that is strangely not what the credit rating agency cares about. In this respect, it is strange that European AAA-rated countries that are part of the eurozone do have such a high rating, while they do not have the ability to autonomously reprint money. Rising long-term interest rates are more indicative of waning faith in a recession and embracing the soft landing scenario.

It did not help that Bill Ackman indicated he is short the 30-year US government bond. Ackman is used to sharing his investment case widely and this form of legal inside information is often part of his strategy. Ackman is counting on that interest rate going to 5.5 per cent. If the US government has to pay an average of 5.5 per cent on the $32 trillion US national debt (and growing), that's $1.75 trillion a year. Per year, the federal government has less than $5 trillion in tax revenue and already the interest burden has doubled in a short time from around $500 billion to $1 trillion. At $1.75 trillion, a third of the US budget goes on interest. Given the other items, this becomes a tough story that can only be solved with monetary financing by the Federal Reserve. Ackman points to the structural inflation factors (deglobalisation, higher defence costs, energy transition, greater government obligations, more bargaining power of workers) and counts more on a persistent inflation level of 3 per cent. Furthermore, he points to the large supply and declining demand for US Treasuries: China wants to decouple financially from the US, and Japan has stopped YCC policy. He also uses the same arguments as Fitch regarding political divisions and the rising fiscal deficit. According to him, then, the long-term inflation expectation is 3 per cent. Add 0.5 per cent real interest rate and 2 per cent term premium and he arrives at 5.5 per cent. For now, nothing will be done about that budget deficit by the green transition and the debt risks rising to $52 trillion by 2033. While Ackman's reasoning is correct, the level of interest rates ultimately depends on the Federal Reserve's buyback policy. The tricky thing for the Fed (and other central banks) is that it is not producers and consumers who are affected by higher interest rates, but rather that today a large part of the debt is in the government, in the case of the US also largely nicely short-funded. The moment a third of US spending consists of interest payments, this means, for instance, no more spending on defence or no more social benefits, or else taxes have to go up.

An economic drawback of a soft landing is that it is still a landing. Relative to the period before, growth weakens. Now, the difference between 1 or 2 per cent growth and no growth is not that big, but it is mainly nominal growth that softens. So besides the real growth weakening, inflation is now collapsing as well. So where until recently companies could count on nominal growth of close to 10 per cent, zero is now approaching. If inflation falls so sharply, it will have a major impact on corporate earnings. Until now, companies were managing well to offset higher costs with higher selling prices, a direct result of high inflation. Now that inflation is falling sharply, this will at some point be noticeable in lower sales, while costs are actually catching up their leg with a delay. There go profit margins.

One valuation disadvantage of a soft landing is that relatively high policy interest rates leave little left of the equity risk premium. This is not a problem if interest rates start falling (e.g. due to a recession), but it is a problem if interest rates start rising. The correlation between big tech growth stocks and real interest rates is high, and thus a larger correction in growth stocks is approaching.