What to Expect When You Are Expecting
Now that COVID-era distortions have moved through the economy, we believe it is time to start trusting the indicators again. Over the last few years, we experienced a huge exogenous shock followed by unprecedented stimulus into a supply-side constrained economy. Traditional recession signals like the inverted yield curve, jobless claims, and contracting PMIs gave false signals because the pandemic and the policy response did not comprise a true economic cycle. We knew we would eventually reach normalization where the temporary supports for growth would fade, allowing traditional economic indicators to regain their predictive power. Growth has slowed from its rapid pace last year, and some cracks are beginning to appear.
The Fed Is in a Position to Cut
Current data supports the case for rate cuts. In June, both headline CPI ex-shelter and core CPI ex-shelter were 1.8% year-over-year, below the Fed’s 2% target and down considerably from their respective peaks of 10.8% and 7.7% in 2022. In terms of shelter, we’ve tracked the easing in real-time and ahead of public data. By replicating the Bureau of Labor Statistics (BLS) methodology and leveraging Blackstone’s proprietary analysis, which utilizes real-time rent prices instead of BLS-reported shelter costs, we find that inflation decreased by an addition 90 basis points (bps). It is only a matter of time before the BLS data catches up with reality.
Figure 1: Actual vs Blackstone Derived Core CPI
Source: U.S. Bureau of Labor Statistics, John Burns Real Estate Consulting, Zelman & Associates, Green Street and Axiometrics, as of June 2024. BX-Derived Core CPI replaces Shelter component of Core CPI with a blended market rate at the following composition: single-family rental housing (83%, accounting for SFR, townhomes and owned houses) at an evenly-split average of John Burns Single-Family Rent Index and Zelman & Associates seasonally-adjusted single-family blended rent growth, multifamily (15%) at the Axiometrics national multifamily effective market rent growth on a 13-month basis and manufactured housing (2%) at an evenly-split average of Equity Lifestyle Properties and Sun Communities reported rent growth.
Later in this edition of The Connection, we present the quarterly CEO survey, which includes key insights on wages.1 We observed that wage growth in our portfolio companies peaked at over 7% in 2022 and has been on a downward trajectory ever since. Notably, Blackstone portfolio company CEOs anticipate wage growth moderating to around 3% in the next 12 months, closer to pre-COVID wage gains. This response coupled with our own analysis suggests that the Fed has enough justification to cut rates.
But They Don’t Have to Cut That Much
Household and corporate balance sheets are largely sound and can handle a slowdown in growth. They will likely be tested, but they are not overextended. Corporations termed out their debt during the era of ultra-low interest rates and have an interest coverage ratio of 14x, an all-time high at almost 3x the historical average.2
In terms of households, almost 90% of US homeowners with a mortgage have a rate below 6%, which has helped debt service and financial obligation ratios as a percent of disposable income remain at 40-year lows.3 Rising real estate values and equity market highs have led to widespread growth of household wealth. Naturally, low-income consumers who do not own homes or financial assets are feeling more of the effects of higher rates. More reliant on credit, this cohort is disproportionately affected by higher costs, and delinquencies are rising.
Similarly, bifurcation is evident among corporations. Despite the Fed keeping rates at a 23-year high and at this level for the second longest period on record, large-cap companies have maintained operating margins near record highs, while small-cap companies’ margins are close to 30-year lows.4
There are two reasons for this stark difference. 1) Smaller companies tend to have less pricing power, and 2) they face difficulty accessing credit, relying more on short-term financing. Nearly two-thirds of small caps have debt maturing in the next five years, compared to less than half of their large cap counterparts.5 This upcoming maturity wall and higher leverage leave small-cap companies more exposed to rising interest costs, which typically increase before margins turn negative.
Preparing for a Mild Rate Cut Environment
Moving beyond the “when” and focusing on the “why” is crucial. Over the last 30 years, most interest rate cuts responded to economic stresses like the 2008 Great Financial Crisis or the 1999 Tech Bubble. What’s less familiar is a cutting cycle with low unemployment, record-setting stock market prices, and all-time high household net worth. This time, the “why” behind the Fed’s cuts is different, and that matters for how investors may consider positioning their portfolios.
Dissipating inflation and restrictive inflation-adjusted interest rates are driving this cutting cycle. Slowing growth will play a role, but we must look beyond recent cycles defined by emergency responses to economic shocks. Three episodes come to mind: 1994/1995, 1984, and 1966/1967.
Figure 2: Effective Federal Funds Rate
Source: Federal Reserve. Red circles represent interest rate cut cycles shaped by dissipating inflation and soft landing – 1966, 1984, and 1995 cutting cycles.
These periods featured inflationary bumps and rising interest rates. But rather than a bubble bursting, Fed easing came after inflation dissipated. Growth slowed without a “financial accident,” Fed cuts were shallow, and the economy avoided recession. Collectively, these soft landings featured fewer interest rate cuts, and in all three instances, the Fed had to pivot back to rate hikes soon after.
The charts below illustrate how these soft landings triggered a different policy response than the other cutting cycles. We track the 18 months following the first Fed cut in interest rates for soft landings (Figure 3) and hard landings (Figure 4). There are two key points. 1) The Fed doesn’t cut as much in soft landings, with the average reduction being almost 30% from peak rates compared to almost 60% from peak rates in hard landings. 2) When the Fed lands the plane, they quickly take off again. Notice how rates trough about 10 months after the first cut but then rise again.
Figure 3: Soft Landings: Change in Average Effective Fed Funds Rate Following First Cut
(Percent of Initial Rate)
Source: Blackstone Investment Strategy Calculations, US Federal Reserve, and Bloomberg. The figure reflects the average monthly change in the effective Federal Funds Rate during interest rate cutting cycles in 1966, 1984, and 1995.
Figure 4: Hard Landings: Change in Average Effective Fed Funds Rate Following First Cut
(Percent of Initial Rate)
Source: Blackstone Investment Strategy Calculations, US Federal Reserve, and Bloomberg. The figure reflects the average monthly change in the effective Federal Funds Rate during interest rate cutting cycles in 1981, 1990, 2001 and 2007.
Soft landings can be seen as an extension of a cycle rather than a new one. This is why the “why” matters (Figure 5). A modest reduction in rates from slowing growth and moderating inflation affects profits, credit spreads, size and style factors much differently than an environment where the Fed is cutting longer and deeper.
Figure 5: In the 12 Months Following the First Cut
Average S&P 500 Performance
Average Change in S&P 500 Earnings
Average Change in IG Credit Spreads
Source: Bloomberg, Standard & Poor’s and Macrobond, Investment grade credit spreads represent the spread between Bloomberg Barclays Investment Grade Corporate Bond Index yield-to-worst and US 10-Year Treasury yield. Increasing spreads reflect market perceived economic weakness. Hard Landing scenario is based on interest rate cutting cycles in 1981, 1990, 2001 and 2007. Soft Landing scenario is based on interest rate cutting cycles in 1966, 1984 and 1995 (average increase in IG credit spreads in based on cutting cycles in 1984 and 1995).
Portfolio Implications
While it is too early to determine with confidence whether the Fed will achieve a soft landing, we remain optimistic that a slowdown in growth is manageable given the strong household and corporate balance sheets. Simply put, they are not stretched compared to more recent peaks in the economic cycle. Therefore, a milder cutting cycle should be our base case as investors. This base case also implies a higher level of interest rates for the next few years.
History shows that periods of higher interest rates translate to lower equity returns as the composition of returns shifts. The S&P 500 had an average annual return of just 6% in a rising rate environment from 1953 to 1981, as compared to 10% from 1981 to 2021 when interest rates structurally declined and price multiples expanded.6 With higher rates, expanding valuations cannot be relied upon. Rather, returns are likely to be driven by earnings and dividends over multiples, and current cash flow and growth over future earnings.
In this higher rate environment, a greater dispersion of returns should be expected. For nearly 40 years, falling rates have shaped how companies operate, leaving many inexperienced with the current conditions. Consider this: the 10-year Treasury yield peaked at 14.6% in 1981 and fell below 1% by 2021.7 With corporate debt averaging a five-year maturity, no rolling five-year period since 1981 has required companies to refinance at higher rates.8 Today, only one S&P 500 CEO, Warren Buffett of Berkshire Hathaway, has experience running a business in a higher interest rate environment. He’s been at the helm for 54 years. The second longest-serving S&P 500 CEO, Blackstone’s Steve Schwarzman, has 39 years of experience.
Nearly 45% of Russell 2000 companies under-earn their interest expense, and there is limited C-suite experience in refinancing and operating businesses in a higher rate environment.9 This dynamic makes identifying high-quality companies with low leverage and recurring cash flow to service existing debt especially important today. As returns from passive investments are likely to be challenged by less support for valuation multiples, active investment approaches become more crucial, and we believe private assets can feature more dominantly in that effort.
In the Guest Column, Gilles Dellaert, Global Head of Blackstone Credit and Insurance, highlights how we leverage our expertise and scale to invest in and finance these high-quality firms across our favorite neighborhoods while providing investors diversified returns.
- The Blackstone CEO Survey referred to herein is a survey of a subset portfolio company CEOs. For 2024, the CEO survey reflects responses from 92 US Blackstone Portfolio companies (59 U.S. CEOs) (the “CEO Survey”). The CEO Survey was initiated on June 10, 2024 and closed on June 20, 2024. The responding portfolio companies are not necessarily a representative sample of companies across Blackstone’s portfolio and the views expressed do not necessarily reflect the views of Blackstone. The views expressed reflect the responding CEOs’ views as of the date of their responses, and Blackstone does not undertake any responsibility to advise you of any changes in such views. Note: See “Important Disclosures” for additional information about the survey and the views expressed within.
- Ned Davis Research, as of March 31, 2024.
- FHFA, National Mortgage Database, as of March 31, 2024.
- Federal Reserve, Bloomberg, Standard & Poor’s, as of June 30, 2024. Operating margins on firm size based on S&P 500 ex Financials and S&P 600 ex Financials.
- Bloomberg, as of November 19, 2023.
- Federal Reserve, Standard & Poor’s as of June 30, 2024. S&P 500 annualized average return based on price returns and calculated from April 1953 to September 1981 and October 1981 to December 2021.
- Federal Reserve, as of June 30, 2024.
- Federal Reserve, as of June 30, 2024.
- Bloomberg, FTSE Russell, as of June 30, 2024. Based on interest coverage ratio of Russell 2000 ex Financials.
