Global financial markets appear to be overlooking critical macroeconomic issues that distinguish the current period from the previous interest rate hiking cycle in 2022-23. The world economy previously absorbed rate increases due to two unusual factors. Firstly, substantial cash buffers accumulated during the pandemic, a result of unprecedented government transfers to households and businesses. These excess savings have largely been exhausted; for instance, US excess savings have plunged from over 10 per cent of GDP to negative 2 per cent.
Secondly, the reopening of international borders precipitated significant population growth in countries like Australia, Canada, and the US. This influx fuelled economic growth through heightened consumption and investment. In Australia, approximately 500,000 net permanent and long-term arrivals over 12 months to January have driven world-beating population growth, which, alongside budget deficits, accounts for most economic growth since 2021. This population surge helped the Australian economy assimilate the Reserve Bank of Australia’s cash rate increase from 0.1 per cent to 4.35 per cent, even aiding a surprising recovery in housing prices. However, if population growth were to slow, the economy would face a very different landscape, amplified by potentially thinner excess savings and any fiscal consolidation.
A second major macro concern is the emerging “credit rationing” by non-bank lenders overseas. This phenomenon can drain liquidity from the financial system, causing asset prices to plummet and triggering a negative feedback loop of defaults. The prevalent “extend and pretend” game, where problematic loans were continually rolled over, is ending as capital rushes from private credit funds. Lenders are now forced to call in loans, leading to defaults and foreclosures that depress asset values. This, coupled with potential US Federal Reserve rate hikes, could precipitate a significant default cycle, further exacerbated by banks reducing their exposure to the private credit sector.
Even with the cessation of hostilities in Iran, the ongoing oil price shock is expected to continue boosting inflation and consumer expectations, likely prompting central banks globally to maintain a tightening stance. Given these complex headwinds, many analysts are favouring positions in cash, floating-rate notes, and liquidity, which offer optionality as new opportunities emerge.
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