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The seeds for the 2023 U.S. recession were sown a while ago by the relentless decline in the Conference Board’s leading economic indicator, which has now declined for eight consecutive months. The data go back to 1959 and I can tell you that at no time in the past have we seen such a string of weakness like this, alongside a 5.6 per cent annualized contraction over such a time frame, without a recession following within a quarter or two. Call it nine for nine back to ‘59 in terms of recession calls. The economic downturn is staring us in the face – and if it is so “priced-in,” why is the consensus calling for positive earnings-per-share growth for next year?
For the U.S. equity market, all we have done in this year’s drawdown is take the lofty price-to-earnings multiple off about four points toward its long-run norm of around 17 times, but mean reversion means you go from one extreme to another; it doesn’t mean settling at the mean – we never do, the average is nothing more than a horizontal line. And we haven’t yet seen the 20 per cent earnings decline typical in a recession. That still lies ahead, as does a decline in nonfarm payrolls, and the inevitable correction in home prices. Remember, equities and real estate, both hypersensitive to interest rates, are 94 per cent correlated and one never goes down without the other.
The biggest problem right now is that the recession is just getting going, or about to, and this bear market in equities at most is halfway done. Once the economists call the recession, and once all the market bulls are carted out on the stretcher, I will be turning very positive on the outlook. Until then, set yourself free of risk and cyclicality, hunker down, and have a stash of cash to put to work when the margin calls come in and the weak hands are forced to dump their holdings at fire-sale prices. Think of August, 1982, November, 2002, and March, 2009, as classic examples – and remember that these lows in the S&P 500 only happened once the recession was in the mature stage, fully priced in, and the Federal Reserve was aggressively priming the monetary pumps.
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When you combine the balance sheet with what the Fed has pledged it will do with the funds rate, we are talking about a de facto tightening in policy that will reach 500 basis points in 2022, which is a degree of tightening we have not seen in such a short time frame since the Volcker era of the early 1980s. (A basis point is one-hundredth of a percentage point.)
The silver lining for 2023? Let me just say that I believe the conditions are in for a substantial decline in inflation. Mostly because the root cause is fading, notably clogged up global supply chains. And demand is softening now that the fiscal stimulus effects are largely in the rear-view mirror.
In other words, it is clear that the inflation burst was transitory after all, and reflected the shift in the aggregate supply curve, which is now in the process of thawing out in both the labour and product markets. With demand growth now slowing down to a trend below that of aggregate supply, or total output, one can expect excess capacity to be the next chapter of the story. For all the talk of commodities, the reality is that oil prices were higher in 2014 than they are today; copper was higher in 2010 than it is today; wheat is below 2011 levels; and shipping rates, like the Baltic Dry Index, are lower today than they were in 2018. High prices are not inflationary. Prices stayed high throughout the Paul Volcker years. Inflation is all about price momentum, and that is clearly subsiding.
Hence my view that the Treasury market has a lot of value right now based on a disinflation and recession view that is not currently priced into any asset class; and the knowledge that every bear market in equities requires the Fed to re-steepen the yield curve, and for the 10-year T-note yield to converge on the S&P 500 dividend yield.
In other words, we never see a recession bottom in stocks happen absent an initial decline in Treasury yields, and the mean and median decline from the Treasury yield peak is 160 basis points by the time equities find a low in a recession bear market; so, I am turning even more bullish on bonds now. (Bond prices and yields move inversely.)
To repeat, no fundamental market bottom has happened as the Fed was still tightening policy and no bottom has ever occurred until deep into a recession, an ensuing Fed easing cycle, and the re-establishment of a normally shaped yield curve.
Cash was king in 2022 and I believe the Treasury market will grab the mantle in 2023 before equities do so in 2024. Bear in mind that the first asset class to enter a bear market is always the first one to come out of it, and it is absolutely going to be necessary for bond yields to decline materially to provide the stock market with the relative-value proposition to establish a true fundamental bottom. The primary issue for the S&P 500, from my assessment of the landscape, is whether the low is 3,100 or 2,700. But either way, we are definitely not there yet and rallies along the way are to be rented, not owned.
What I know from studying all the past 11 recessions since 1950 is that the long bond makes you money in recessions in terms of total return, no matter where the inflation rate is, because inflation declines in all recessions, including the three we experienced in that horrible stagflation period from 1970 to 1980. Equities, on the other hand, always lose you money; the only question is magnitude. But the asset mix, given what’s being discounted, augurs for being overweight bonds (at this point) and underweight equities.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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