Lara Rhame is chief U.S. economist for FS Investments, a $35 billion alternative asset manager. She is responsible for analyzing developments in the global and U.S. economy and financial markets and providing a fresh take on macroeconomic issues.
Russ Alan Prince: Inflation hit a 40-year high in 2022, and the Fed has had to play catch-up with rate hikes. When will the Fed pause, and what impact are their rate hikes having on inflation and the economy?
Lara Rhame: One could argue that the Fed’s rate hike cycle that began in 2022 was truly unprecedented and has caused a generational shift in the way we should think about returns on traditional investments. The Fed has raised rates over 400 basis points in under a year, the most aggressive rate hike cycle since the early 1980s, and they may still raise rates further. This has had a powerful impact on our economy.
Interest rate-sensitive sectors, like the housing market, are ground zero for the crush of rate hikes. Until 2022, the Fed held rates at zero for nine of the last 12 years, which supercharged large-tech high-growth companies that dominate traditional equity indices. When interest rates are meaningfully higher than the average dividend of equities, future growth and earnings are more discounted, decreasing the present stock value. When rates are no longer zero, in other words, expect traditional equities to underperform, the mirror image of their outperformance over the past 15 years.
Prince: The 2023 economic outlook is a hot topic. Many economists are calling for a recession, but growth has remained solid and the unemployment rate is low. Where do you fall on this important question?
Rhame: The Fed rate hike cycle has significantly raised the probability of a recession at the end of 2023 or early in 2024. Historically, the U.S. economy dips into a recession about a year after the Fed stops raising rates. We are rooting for a “soft landing,” but our base case is that we will see a mild recession.
The Fed is notoriously bad at executing a rate hike cycle without a recession. The good news is that despite cyclical headwinds, primarily the Fed working to slow the economy through higher interest rates, there are secular tailwinds that should help avoid a severe recession.
Real estate is an important example: we have seen a big drop in activity as interest rates and mortgage rates have risen. But over the past decade and a half, we under built homes, so there is a shortage of supply. This will limit the decline in prices, despite the gap in activity and a normalization of sky-high prices. Commercial real estate is considered a business investment and here we have also underinvested over the past decade. Again, this is an interest rate-sensitive sector of the economy and we have seen the expected decline in activity and some correction in prices, particularly large office spaces in major city centers.
Other sectors and regions are still actively building, including industrial and multi-family, as supply has lagged in demographic and other economic trends. Higher interest rates and economic uncertainty are definitely short-term headwinds that will impact activity and could lead to a recession, but there is important and powerful resilience, especially in the medium term.
Prince: It seems like economic uncertainty is going to be a recurring theme for much of the year. What does this mean for markets?
Rhame: Economic uncertainty, driven in large part by policy uncertainty, will weigh significantly on traditional assets. The nominal GDP is set to slow rapidly. Remember, nominal growth aligns with corporate revenues. In 2021, despite rising costs and lingering disruptions from the pandemic, companies were able to pass along higher costs to consumers; in essence, this pricing power is inflation, and companies experience this as higher margins. Nominal GDP grew 10.7% in 2021 and 9.2% in 2022, and companies experienced strong earnings growth.
Looking ahead, in 2023 our expectation for real GDP is 1.0% growth with the first half stronger than the second half, and inflation ending the year around 3.5% year-over-year. This means nominal growth will decelerate sharply to around 4.5% and companies will likely experience either a slowdown in revenue, tighter margins, or both.
Unfortunately, inflation persisting above 2% also means that stocks and bonds will remain highly correlated. For 20 years, as inflation held below 2%, investors were treated to stocks and bonds delivering diversification; in the years that equities were down, bonds delivered healthy positive returns.
Prince: If traditional assets are likely to remain highly correlated in this challenging growth environment, how can investors diversify their portfolios and manage through volatility?
Rhame: A key takeaway of 2022 is that investors need alternatives. In an environment where traditional assets are highly correlated against a backdrop of heightened macroeconomic uncertainty, investors have a rich variety of alternative investments that can add diversification, enhance yield and provide stability in portfolios.
Liquid multi-strategy funds can protect downside exposure while participating when equities increase. Investments with shorter duration offer both stronger returns and allow investors to enhance yield as the Fed continues to raise rates. Finally, some investment areas are shifting rapidly. Commercial real estate remains attractive in the medium term, but equity gains in this sector may have peaked as a casualty of high mortgage rates. Accessing CRE investments through debt means the investment is higher in the capital structure and can provide a more stable return.
Russ Alan Prince is the executive director of Private Wealth magazine and chief content officer for High-Net-Worth Genius. He consults with family offices, the wealthy, fast-tracking entrepreneurs and select professionals.
