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This downturn will come in the next few quarters, not the next few years
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The year 2023 has been a “soft landing” transition much like 2007, when the consensus and many market participants mistakenly assumed the recession would never come, and failed to see that we were on a bridge morphing from the expansion phase of the business cycle to the contraction phase.
People talk about the fact that there are no asset bubbles this time around, but both the housing and equity markets are more expensive today relative to incomes and profits than they were at the 2006-07 bubble peaks. Pundits claim that balance sheets are in terrific shape compared with 2007, but that begs the question as to why credit-card and auto loan delinquencies are rising inexorably in advance of any deterioration in the labour market.
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Yes, the banks are very well capitalized today, but the leverage is concentrated in the non-bank “shadow” finance market (as in private debt equity and leveraged loans). It must be said that in that mid-2000s cycle, there were endless tales being spun that we were headed into a new super cycle of inflation from China’s ascension and that the business cycle was dead — the term “consumer resilience” was all the rage. As is the case today, the yield curve inversion of 2006, which switched to an “un-inverted” state in 2007, was completely ignored.
Investors bought into the “new era” narrative hook, line and sinker, taking the 10-year T-note yield up to 5.3 per cent that summer and the S&P 500 to new all-time highs that fall. The funds rate that cycle was taken from one per cent to 5.25 per cent. This current rate cycle has already surpassed that. The United States Federal Reserve was done tightening in the summer of 2006, and while it remained hawkish in word, an easing cycle that precious few saw coming did arrive by late summer 2007 — but was not enough to save the economy, as the National Bureau of Economic Research-defined recession commenced that December.
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None of the prior lagging and coincident indicators, from employment to retail sales to production, helped the consensus opinion at the time — only showing that we were in an official downturn in the summer of 2008, eight months after the recession actually began.
As with the three U.S. banks that failed this past March, everybody believed that the failures of New Century Financial Corp. and Bear Stearns Companies Inc. were idiosyncratic and isolated events, to be “contained.” People would have been better off trying to figure out what other skeletons were set to fall out of the closet.
As we are seeing currently, it is taking a good while for the aggressive Fed stance to show through in the data. The lags were long in the mid-2000s just as they are today. Fiscal stimulus was an antidote then, in the form of the George Bush tax relief and the spending binge generated by the invasion of Iraq. The consumer sector continued to garner cash flows from the last vestiges of the housing bubble (mortgage equity withdrawals and cash-out refinancings).
And what do we see today? Government support for industrial construction and a household sector that clung to the cash support from the prior Biden Budget Buster in March 2021, a proverbial gift that kept on giving. Basically, what Uncle Sam did was gift everyone with a pulse the equivalent of over two years’ worth of personal income (on top of the paycheques that came our way naturally after the economy reopened). And virtually everyone threw in the towel on the recession call this year (not us), just as they did prematurely in 2007.
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The bond bulls were ridiculed that summer (China-led inflation) and the equity market bulls just kept pointing to the “soft landing” narrative as well as to rising EPS forecasts by the always reliable universe of Wall Street equity analysts. As for the Fed, it’s a case of the song remaining the same — the “higher for longer” tune. Since when is that new? The Fed kept the funds rate at the 5.25 per cent peak for nearly a year-and-a-half. Next thing you know, Ben Bernanke was publicly apologizing to Milton Friedman for nearly causing another Great Depression.
So, I am willing to acknowledge that the recession has been delayed. But it has not been derailed. There are almost always long lags between the initial Fed hike, the start of the yield-curve inversion, the peaking-out in the Leading Economic Indicator, and the time that the Federal Reserve Bank of New York recession model crosses above that 70 per cent “nevertheless turn back” probability threshold.
The lags are longer this cycle than normal for the reasons cited above, and understanding these dynamics held me in good stead in 2007 despite the intense pressure I felt from within Merrill and outside those walls from much of the client base who bought into the “new era” thinking of the time: that interest rates no longer mattered, that the business cycle was dead, that the housing market had entered a structural bull market and that the future was one of a commodity-led inflation boom (so sell all your bonds, as the fixed-income strategists advise, as the 10-year T-note yield was piercing that five per cent level in the spring and summer of 2007).
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Yet here we are on this round trip back towards this mark and I sense once again the pain of enduring a vicious bond bear market will cloud the investor decisions on what to do next … which should be to add duration. Always a prudent thing to do at or near the peak in yields. I will finish off with my religious belief that the business cycle, contrary to popular opinion, is not dead; that policy lags do exist and the current one is much longer than normal.
This recession will come in the next few quarters, not the next few years. And this will be when the job loss and default cycle ushers in a more intensified disinflationary cycle and a new bull market in Treasury notes and bonds. I’m bloodied but unbowed, and not willing to surrender to the legion of new “new era” advocates.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.
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