The deniers are out in full force. Janet Yellen and President Joe Biden don’t want to use the word “recession” because it sounds so terrible. Like a contagious disease. So instead they use the word “transition.” Oh, that sounds so much better, don’t you think? But will they tell us what exactly we are “transitioning” into?
Keep in mind that the Federal Reserve only started tightening policy in March, and in a span of just four months, its stance has moved from uber-accommodative to neutral. The back-to-back negative quarters in U.S. GDP to date have yet to include the effects of the Fed’s actions, which will place further pressure on the economy. What has undermined the economy in the first half of the year has been: (i) the big inflation shock eroding real economic activity; (ii) the acute, indeed record, fiscal drag; (iii) the hit to confidence from the slide in the equity market; (iv) the weakness in overseas macro conditions, which hit the U.S. trade deficit hard in the first quarter; and (v) the impact of liquidating excess inventory in the second quarter.
We haven’t yet seen employment shrink and home prices revert to the mean. This comes next.
Historically, after the Fed tightens 225 basis points (as it has since March), recessions ensue nine months later. The yield curve only began to invert – a scenario in which short-term debt has a higher yield than long-term debt – in April, and the average time it takes for a recession to follow is 10 months. So, as bad as the economy has been through the first half of the year, we ain’t seen nothing yet. The lagged effects of what the Fed has already done are yet to come down the pike, and the GDP data are going to get worse, not better.
So if the stock market has rallied on expectations of a “soft landing” or “short and shallow” recession as opposed to just a short-covering rally, then big disappointment lies ahead.
But recessions don’t mean the end of the world as we know it, they merely are part and parcel of the business cycle. This is a time to be disciplined, not emotional. And waiting for the National Bureau of Economic Research to make the official declaration may be the stupidest thing I have ever heard, because that declaration typically comes seven months after the recession started.
And even when the Fed pauses on rates, the central bank will still be shrinking its balance sheet – and that will be the equivalent of a further 100 basis points worth of policy tightening this year. Given the lags from a 225-basis-point rate hike and from the time of the yield curve inversion, we are talking about the big hit to the economy coming in the first and second quarters of 2023. And seeing as the stock market typically bottoms around five months before the recession ends, it would be totally irresponsible to be calling for a true fundamental trough so early in what is likely to be, at the least, a six-quarter recession. The thing is – of all the plausible scenarios we have constructed, the best-case scenario is the S&P 500 at 3,100, or down at least 20 per cent from where we are today.
And there are further points for consideration. At the June lows, sentiment was extremely depressed across every survey. As for market positioning, we also know that we just came off the largest net bearish bets being placed on the S&P 500 in the CME Futures & Options pits since June, 2020. We had no fewer than eight interim bottoms in the stock market in both the 2000-02 and 2007-09 bear markets over both those two-plus-year downtrends. You’ll know the bottom has been reached because it always comes in the mature stages of the recession – and this one is just getting going – and the catalyst has always come from the Fed cutting rates to the bone. In both those prior down-cycles, the end came only after the Fed cut rates 500-plus basis points, which it will not have the luxury of doing this time around. That will cloud the prospect of any meaningful recovery soon after the recession. The words “secular stagnation” will once again be rolling off our tongues.
Moreover, the internals of the equity market leave me less than enthused. There is no true bottom until we get a conclusive low in the asset-manager stocks and I see little evidence that this is happening. The group is still down more than 30 per cent from the highs and its relative strength (RSI) is down 20 per cent. Through this market rebound, it has been growth outperforming value stocks and defensives outperforming growth. This is not what you want to see if you are a believer that the market is anticipating a postrecession recovery. Transport stocks remain in a downtrend and relative to the market are down 10 per cent, and relative to utilities are off 24 per cent. The relative performance of consumer discretionary to staples stocks also remains on a downward trajectory. The performance of retail REITs in comparison to the REITs index has been deteriorating and again speaks to the erosion in the broad consumer sector. Banks and consumer-finance stocks are also underperformers. Without the financials leading – instead of lagging – all bets are off on the veracity of this bear market rally.
Fun to trade, but don’t stick around too long.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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David Rosenberg