I’ll give you my major conclusions up front and then explain the thought process.
First, the United States is in a recession and the only questions are how deep, and when does it end?
Second, we are in a fundamental bear market in equities, and the fundamental cycle lows will not be turned in ahead of a reversal in Treasury yields. In other words, the bear market bottom in stocks needs lower bond yields, so if you are going to turn bullish on anything first, attention has to turn to the Treasury market.
Third, inflation has peaked and I think in the coming year will surprise more to the downside than upside, and we will learn that the term “transitory” in this context was 16 months. This certainly is not the 1970s and never was. Our models show that headline U.S. inflation will be well south of 3 per cent by this time next year, and that includes assumptions over the inherent stickiness of service sector prices, primarily rents, which are a lagging inflation indicator, in any event. (It’s a sorry state of affairs that this is what is dominating the Fed’s attention at the current time.)
It’s as if for most people on Wall Street there is no such thing as a recession, even though we know for a fact that there have been 11 of them since the Second World War. The reality is that while back-to-back declines in real GDP are not the actual technical definition of a recession, the reason why it’s a handy rule of thumb is because every time we’ve experienced this condition, the economy has actually been in recession. Every time we’ve had the maligned two-year/10-year Treasury yield curve inverted as much as it already has, the economy has slipped into recession 100 per cent of the time. And we have never before seen domestic cyclical stocks down more than 30 per cent – from any peak over at least a six-month span – without signalling a recession.
Historically, these come amidst or in the aftermath of a Fed tightening cycle, and so this is the context we have to view the market environment.
We have a tried, tested and true amalgam of economic and market signals contained in the U.S. Conference Board’s Leading Economic Index, which has a rich history all the way back to 1959. I want to stress that as people, including the Fed, focus on the low level of unemployment, that is actually part of the index of lagging indicators. At the same time, the U.S. nonfarm payroll data, which suddenly caused many people and the markets to buy back into the “soft-landing” view, is an ingredient in the index of coincident indicators. U.S. payrolls often rise into the recession, only to get revised down sharply when they diverge from the separate household survey, which has a smaller sample size but is historically far more accurate at catching turning points in the business cycle, in both directions.
The danger, as I see it, is that this Fed, with a chairman who, back in March in front of Congress, compared himself to Paul Volcker, is focused primarily on lagging and coincident indicators. And Mr. Volcker of course is celebrated as the greatest inflation dragon slayer of all time, and he did that by generating back-to-back recessions in 1980 and again in 1981-82, and a three-year bear market in risk assets in the process.
We got the July reading on the Conference Board’s Leading Economic Index a few weeks ago. It fell 0.3 per cent on the month and it marked the sixth monthly contraction in a row. Not once in the past have we endured six consecutive declines without heading into a recession. I think that’s all anyone really needs to know.
I see some pundits saying we should all just wait for the National Bureau of Economic Research to make the official declaration, but that is a crazy piece of advice since historically the Bureau makes the announcement seven months after the recession has already started. In fact, the NBER made the declaration in December, 2008, which was a full year after the recession began.
This is all very important because in market corrections that take place around a soft landing, typically half of the prior bull market condition is reversed. If you are in the soft-landing camp, based on that arithmetic, the market did in fact bottom in the middle of June. But in recessionary bear markets, where the compression in the market multiple collides with an earnings recession, historically 83.5 per cent of the prior bull market is reversed, and that would put the fundamental low for the S&P 500 closer to 2,700. As an aside, that is just an average – half of the recession bear markets in the past saw the entire bull market advance completely vanish by the time the lows are turned in.
Our own research found that for the Fed to target financial conditions consistent with its 2-per-cent inflation objective, we would need to see 3,100 on the S&P 500 and at least 700 basis points on high yield spreads (the difference in yield between treasuries and junk bonds). I think these are the best levels on both we can envision, barring an early pivot away from hawkishness by the Fed.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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