The US Economy Is Defying The Laws Of Gravity. Here’s How.

With its latest interest rate hike, the Federal Reserve (the Fed) has raised the cost of borrowing by a whopping 5% in just a little bit more than a year. With that kind of pace, you’d expect the economy to be gasping for air, but it’s actually breathing easy – and defying expectations. And it’s worth taking a moment to consider how that’s happened.

Why is the US economy doing so well?

Consumer spending has stayed strong, fueled by pandemic savings.

Covid lockdowns and government aid meant US consumers were spending less and socking away more, and that helped create a hefty savings buffer. This piggy bank powered their spending spree, initially on goods (all those Pelotons and home office furnishings), and more recently on services (cue the travel, Michelin-star dining, and glammed-up hairdos). Those savings are starting to dwindle, but a robust job market and renewed consumer confidence are keeping the spending going – a big deal, since the US economy counts on this for over 70% of its growth.

Businesses and consumers played the long game with low rates.

After the global financial crisis, fixed-rate, super-cheap debt became all the rage: it lets consumers and businesses lock in ultra-low financing for years and years. So whether it was auto loans, mortgages, or long-term bond financing, much of the debt that’s out there still bears the sweet low yields of yesteryear. A lot of businesses have actually seen their interest costs relative to profit shrink. And, by successfully passing the buck of higher prices to consumers, they’ve kept their margins fat and healthy. So, it might be a while before interest rates really hit home for the economy.

The big fiscal guns came out.

The Biden administration pushed hard for a $1 trillion infrastructure package, along with legislation that injected capital into the renewable energy and semiconductor sectors, which gave the economy a much-needed adrenaline shot. The bill, signed in late 2021, fueled a boom in manufacturing and infrastructure, leading to an 8% annualized uptick in business investment in the second quarter of this year. This fiscal boost helps explain the US economy’s relative resilience.

A worker shortage has kept hiring strong.

The labor market's playing a high-stakes game of musical chairs, and the lack of seats has actually been a win for the economy. This acute worker shortage might have shielded employment from the damaging effects of higher interest rates and has prompted firms to hoard their talent. It’s also turbocharged wage growth, padding out disposable incomes, which, in turn, puts some extra gas in the economic tank.

And a shortage of houses has kept the real-estate market from cratering.

Housing: it's so often the economy’s canary in the coal mine – first to feel the potentially ill effects of higher interest rates. But this bird’s still flapping its wings. And because this sector is so important, that’s been good news for the economy as a whole. While high interest rates have made buying a home a steeper climb, an acute housing shortage has kept prices from plummeting. Savvy sellers have exacerbated the supply issue, but this resilience in the housing market has thrown the economy a lifebuoy, even as the average rate on a 30-year mortgage rose to more than double what it was two years ago.

So does that mean the US economy is in the clear?

Just a few months back, the idea of the Fed executing a “soft landing” (i.e. hiking rates just enough to curb inflation, but without bringing about a recession) seemed like wishful thinking. Now, it's becoming the go-to scenario among economists. With inflation playing ball and falling to just 3% in June – not far from the long-term 2% goal – the Fed might be able to take an extended breather from further rate hikes. As these elevated interest rates continue to trickle into the economy, we could see inflation fall even more (a tad over 2% could still get a pass), but without an economic halt that’s too abrupt. And if the slowdown starts feeling a bit too jarring, the Fed's always got its rate-cutting toolkit handy – and investors are already betting it’ll use it next year.

Alright, so this is where I'll hold my hand up high and confess that I've been a bit of a Debbie Downer on the US economy for some time, perhaps underestimating the factors I've just laid out. That said, I’d gently warn about popping the Champagne too soon. Despite the increasing odds of a soft landing, there are a couple of hurdles along the way.

The first is a possible return in inflation, which could prevent the Fed from cutting rates, or worse, force it to raise them even higher. The easy part of inflation's downhill journey is behind us; what's ahead could be more treacherous. Commodity prices are holding steady and the stubborn inflation in the service sector is still flexing its muscles. A pickup in the economy could even kick those things up a notch – a curveball the market isn't at all prepared for.

The second is a hard brake on growth, which may happen later than expected. The effects of rising interest rates are complex and unpredictable, both in terms of timing and magnitude. And the pandemic has only made it even more challenging to read the tea leaves. While the economy's been holding its own, it might be that the factors we've discussed have only kicked the economy’s troubles down the road rather than moved them out of its path. And the longer the interest rates stay at this altitude, the greater the risk of a financial tumble or a late-blooming growth shock. It wouldn’t be the first time that higher interest rates played the long game, turning what seemed like a soft landing into an exceptionally rough one. Let's remember, the Fed has only pulled off one soft-landing in its history.

So, yes, the macro weather forecast is predicting more sunshine than it did a few months back, giving you reasons to don your optimistic sunglasses. But I'd still recommend keeping an umbrella handy. Even when the short-term forecast is clear, a sudden storm cloud can gather.

So, basically, hang onto the optimism, but keep it on ice?

Right. And remember: in times like these, it’s not a bad idea to spread your investment wings a bit wider. So you can keep your US tech stocks, but consider throwing in some different sectors (including defensive havens like consumer staples and healthcare), regions (stocks from Europe, emerging markets, and Japan could help diversify your risk), and asset classes (gold and Treasury bonds tend to perform well in a slowdown, while other commodities could be primed for a rally if growth holds steady). And, as ever, keeping some cash (and, for once, it’s high-yielding) as dry powder could give you the edge to seize opportunities in what could shape up to be a more roller-coaster-esque environment.

At the end of the day, smart investing isn’t about seeing into the future: it’s about making sure your portfolio can withstand a range of scenarios, including the ones your crystal ball doesn’t foresee.