Soft landing or hard fall? Why investors should pay attention

Key Takeaways:

• The Federal Reserve can achieve soft landings by slowing economic growth to control inflation without causing a recession; hard landings can occur if this effort fails, resulting in economic contraction.

• Different assets react differently in the two scenarios. Defensive investments (treasury bonds, utilities, consumer staples) generally perform better during hard landings, but quality growth companies can still thrive in soft landing environments.

• Instead of trying to time the market perfectly, construct a portfolio that can withstand either scenario and adjust allocations accordingly.

The Federal Reserve is a major player in managing the U.S. economy’s ups and downs. The Fed’s dual mandate is to maintain price stability and maximize employment. In order to achieve these objectives, it uses a variety of monetary policy instruments to influence economic conditions, with interest rates being the most widely discussed.

The Fed would raise interest rates to cool down the economy when inflation rises too quickly. The difficulty lies in finding the optimal balance – tightening monetary policy enough to control inflation without triggering a recession. Economists refer to this delicate balancing act as trying to achieve a “soft landing.” However, history shows that achieving this balance is extremely difficult, and the alternative (hard landing) can have serious consequences for investors and the wider economy.

What Is a Soft Landing vs. a Hard Landing in Economics?

A soft landing occurs when economic growth slows following a period of rapid expansion. As part of a soft landing, inflation gradually returns to target levels while moderate economic growth persists. There is a relatively stable unemployment rate, corporate earnings adjust without major disruptions, and financial markets experience limited volatility.

Picture a pilot gently guiding a plane towards the runway. The descent is well-controlled, passengers don’t experience any turbulence, and the landing is smooth. In economic terms, this means that businesses and consumers may feel some pressure due to higher interest rates, but the overall economy continues to function well. Companies may delay hiring rather than implement layoffs, and GDP growth may moderate rather than contract.

In contrast, a hard landing occurs when attempting to cool the economy leads to a recession. Sharp contractions in economic activity cause job losses in multiple sectors. As households tighten budgets in response to economic uncertainty, consumer spending decreases. Then companies are confronted with declining demand, which results in reduced profits. Investors start reassessing valuations in light of deteriorating economic conditions, which triggers asset price corrections across the stock and real estate markets.

In our airplane analogy, a hard landing occurs when the descent is too steep, leading to severe turbulence, and the landing is rough and dangerous. The economic slowdown’s severity and duration are the main differences between soft and hard landings. When there is a soft landing, growth is moderated without much economic pain, while when there is a hard landing, the economy contracts significantly and can take years to recover from.

What Are the Main Causes of Inflation?

Inflation is the rate at which the price of goods and services rises, resulting in a decrease in purchasing power. Understanding the causes of inflation can help explain why achieving a soft landing is so challenging. Here are the types of inflation:

Demand-pull inflation occurs when demand exceeds supply. Prices increase when consumers have more money to spend on goods and services than the economy can produce. This can occur in times of strong economic growth, when unemployment levels are low, government funding is a source of cash, or when expansionary monetary policies maintain low interest rates for a long period.

Cost-push inflation stems from the supply side. When production costs rise, businesses usually pass these higher costs on to consumers through price increases. This type of inflation is caused by rising raw material prices, higher energy costs, supply chain disruptions, and increased labor costs. For example, the global supply chain experienced significant disruptions during and after the COVID-19 pandemic, which drove up prices even when demand remained constant.

Monetary inflation happens when the money supply is growing faster than the economic output. In this case, the value of each dollar decreases, leading to higher prices throughout the economy. Excessive money printing by central banks, rapid credit expansion within the banking system, or currency devaluation are all possible causes of this type of inflation.

When people expect prices to rise, inflation can become self-fulfilling. Workers demand higher wages in anticipation of rising living costs, and businesses raise prices anticipating higher input costs, and the cycle repeats itself. Breaking this psychological cycle without causing a recession is one of the main obstacles to achieving a soft landing.

What Are the Components of Monetary Policy?

In order to influence economic conditions and guide the economy towards either expansion or contraction, the Federal Reserve relies on several interconnected tools. Investors can benefit from understanding these tools as they can then adjust their portfolios based on the Fed’s decisions.

The Fed relies on interest rates as their primary tool, particularly the federal funds rate, which banks use to borrow reserve balances from other banks overnight. When the Fed raises this benchmark rate, the effects have an impact throughout the economy. The cost of borrowing increases for both businesses seeking capital for growth and consumers financing major purchases. This typically slows down economic activity as spending decreases across various sectors. When demand cools, inflation pressures generally ease, helping to stabilize prices.

On the other hand, when the Fed lowers rates, borrowing is easier. This encourages businesses to invest in growth and consumers to purchase homes, vehicles, and other big-ticket items. This stimulates economic activity and helps accelerate growth.

The stock market usually reacts quickly to interest rate changes or even signals about future interest rate direction. Rising rates tend to cause a decrease in stock valuations, particularly for growth companies with future profits and businesses with high debts. Rate cuts or pauses often boost equities because the cost of borrowing is lower and future earnings become more valuable in present-day calculations.

Reserve requirements represent another monetary policy tool that the Fed may use. Basically, it requires banks to hold a certain percentage of their deposits as reserves. By modifying these requirements, the Fed can influence the amount of money banks can borrow. The reduction of lending capacity and the restriction of credit creation by higher reserve requirements can potentially slow down economic growth. On the other end, lower requirements can increase the availability of credit in the economy, which can potentially stimulate activity. These changes have an immediate and direct impact on the liquidity in the financial system. And this can affect everything from mortgage availability to business loan terms.

Open market buying and selling government securities is another tool that the Fed uses to adjust money supply. Buying securities injects money into the economy as the Fed credits the selling banks with reserves, promoting expansion by increasing the funds available for lending. By selling securities, money is removed from circulation, which helps to control inflation by reducing available credit.

The stock market has a tendency to react positively to buying open market operations because increased liquidity often flows into financial assets. When the Fed reduces its balance sheet by quantitative tightening, markets may feel downward pressure due to less liquidity available.

Historical Examples of Hard and Soft Landings

In the recent decades there have been a couple of notable examples of when a soft landing was achieved and when it failed.

The Mid-1990s Soft Landing

The mid-1990s demonstrate an example of a successful soft landing engineered by the Fed under Chairman Alan Greenspan. In 1994, with inflation concerns mounting after several years of economic growth, the Fed doubled interest rates from 3% to 6% in 12 months (which was a relatively aggressive approach). Despite this sharp increase in borrowing costs, the economy continued growing, but at a more moderate pace.

That time, a soft landing was made possible due to the calibrated approach to monetary tightening combined with transparent communication about the Fed’s intentions. Unemployment remained stable throughout the period, and inflation moderated without triggering a recession. By 1995, with inflation threats sufficiently contained, the Fed began gradually reducing rates again.

The 2008 Hard Landing

The 2007-2009 financial crisis is a completely opposite example: it represented one of the most severe hard landings in modern economic history. There were several factors that prevented the Fed from achieving a soft landing during this period.

• The housing bubble grew too large before serious intervention began.
• Financial institutions had taken on excessive risk through complex mortgage derivatives, thus masking the true extent of market weaknesses.
• Regulatory oversight was insufficient to identify and address these systemic risks.

Although the Fed began raising rates in 2004, it underestimated the fragility of the housing market and the extent to which financial institutions had become dependent on continuous home price appreciation.

When the bubble finally burst, unemployment soared to 10%, GDP contracted sharply, and the S&P 500 lost over 50% of its value.

The recovery from this hard landing called for extraordinary steps, which included near-zero interest rates for years and multiple rounds of quantitative easing that expanded the Fed’s balance sheet to unheard-of levels.

Headwinds & Tailwinds

The economy’s soft or hard landing is influenced by several economic factors, creating both challenges and opportunities for investors:

Tightening credit conditions often precede hard landings as banks become more cautious with lending during periods of economic uncertainty.

The commercial real estate market introduces another potential complication. Because banks maintain substantial exposure to commercial properties through their lending portfolios, any major distress in this sector could restrict the banks’ ability to extend credit elsewhere in the economy.

Rising debt across various economic sectors may limit resilience when faced with monetary tightening.

• Government debt can potentially constrain fiscal policy options during difficult economic times.
• Corporate debt has similarly expanded during years of low interest rates. This leaves some companies vulnerable to refinancing challenges.
• Household debt, while generally more manageable than before the 2008 crisis, can still represent a potential constraint on consumer spending if the economy deteriorates.

The yield curve’s shape provides important signals about market expectations. When short-term interest rates exceed long-term rates (thus creating an inverted yield curve), it often signals market pessimism about future growth prospects. This indicator has preceded most recessions in recent decades.

On the positive side, several tailwinds could support a soft landing:

• The housing market is still showing a good level of resilience despite higher mortgage rates. Limited inventory and high demand continue to support home values in many regions.
• The labor market‘s continued strength is another positive factor. Low unemployment and steady wage growth can help sustain consumer spending even as interest rates rise, cushioning against economic slowdown.