There’s a chance we’ll have a recession within 12 months. At least that’s what most economists believe. What I believe we’ll discuss in a moment.
What I do believe is being prepared. Basically that means being conservative with your finances, ready to live through a tight economy and ready to grab opportunities as they arise. It doesn’t mean cutting your lifestyle back – unless you’re living presently way beyond your means. You shouldn’t be borrowing to finance your extravagance (aka lifestyle).
I don’t owe anyone any money at present. That’s not unusual because I only once borrowed money. That was to buy the business a small office building. But the moment we had the money, I paid the bank loan off. That felt good because I was paying the bank 14% interest. Yikes. Remember those days?
That was it. These days the real estate syndicators I’m investing with are cutting their LTV (loan to value) ratio down – to often under 60%. They don’t want to lose the property, so — if the recession does show its ugly face — they can handle a cut in the rent-roll.
As you know, I have a lot of treasuries. They’re backed by the full faith and credit of the U.S. government – which still looks pretty good to me. Despite some of the new nutcases in Washington.
The $64 question is ‘Are we going to have a recession?’
Recessions are caused by:
+ Banking stupidity – too many crappy loans.
+ Prices of assets that crash after they got too high.
+ Government mismanagement – like zigging when they should be sagging.
+ The Fed too aggressively raising interest rates and too aggressively sucking money out of the economy (called selling the bonds it owns).
+ Black swan events, i.e. stuff happening even I can’t predict. (Modesty is not my strong point.)
Things in economics are pretty weird at present. Russia’s Ukraine war has hurt much of the world’s economy. Russia is totally unpredictable — except that Putin probably won’t let up until we grab the Kremlin and he kills himself in some deep bunker.
What got me thinking these depressed thoughts was a remarkably well-done piece in the Economist magazine. Read this and think what you should be doing to prepare yourself for a peaceful life through potentially unpeaceful times?
Investors expect the economy to avoid recession
Unfortunately, they have a terrible record of predicting soft landings
With its trajectories, headwinds and tailwinds, the language of central banking abounds with aviation metaphors. Little surprise, then, that the policymaker’s most heroic feat is named after Apollo 11’s success in the space race. For wonks, a “soft landing” occurs when heat is taken out of the economy without causing it to veer into recession. Yet the phrase’s illustrious origins hide an ignominious reality. The first time such a landing was predicted, in 1973, by George Shultz, America’s treasury secretary, things did not go to plan. A recession began almost immediately; inflation blazed for the rest of the decade. Prices finally cooled under Paul Volcker, a Federal Reserve chairman, but only after interest-rate rises tipped America into successive recessions and the worst joblessness since the second world war.
Though Mr Shultz’s forecast was catastrophically wrong, it was not unusual. As Michael Kantrowitz of Piper Sandler, an investment firm, has pointed out, investors often think a soft landing lies ahead as a Fed tightening cycle comes to an end. That is exactly what is happening this time around. Since October, the s&p 500 share-price index of large American firms has risen by 16%. An index of investment-grade corporate-bond prices compiled by Bloomberg, a data provider, has rallied by 9%. Worries about recession, overwhelming a few months ago, seem almost forgotten.
If history is any guide, such fears are likely to return. It is not that soft landings are impossible. Since the 1970s, Fed policymakers have managed them precisely twice. In 1984 and 1995, America’s stockmarket began to rally just as interest rates reached their peak. Investors who bought early were rewarded with sustained, multi-year bull markets.
But there have been six other tightening cycles in the past 50 years, and all were followed by recession (even if the sixth, in 2019, was complicated by the covid-19 pandemic). One lesson is that soft landings are rare and hard ones more likely. The more troubling lesson is that, in the early days, the two scenarios are indistinguishable based on how stockmarkets behave. Before each of the hard landings, share prices began to rally, in some cases for up to a year. Then things started to go wrong. The economy sputtered, optimism fizzled and stocks plunged.
Mr Kantrowitz’s explanation for the similarity between the very different scenarios is that, at least in the early days, hard landings look a lot like soft ones. Both feature interest-rate rises, followed by a pivot as the market prices in future cuts, and shares begin to rally. For the soft landings, this is the end of the story. But for the hard ones, the worst is still ahead: employment weakens, along with housing, and investors take a battering.
Therefore buoyant share prices today offer little information about whether the Fed’s present tightening cycle will end happily—a matter on which opinion remains sharply divided. More cheerful types, chief among them Joe Biden, America’s president, point to an impressively resilient economy and a labour market that is booming despite the swiftest series of interest-rate rises since Volcker’s era. Others fear, however, that the impact of rate increases is still to come. Edward Cole of Man Group, an asset manager, worries that tightness in the labour market and an excess of household savings—both leftovers from the pandemic—are delaying the pain of monetary tightening that will eventually be felt. The average response of 71 professional economists surveyed in January by the Wall Street Journal, a newspaper, puts the probability of recession in the next 12 months at 61%.
If the stockmarket is an inadequate guide, other indicators have more predictive power. Unfortunately, they present a less rosy picture. In previous Fed tightening cycles, soft landings were typically preceded by relatively low inflation, and accompanied by looser bank-lending standards. Today’s circumstances are the exact opposite.
The surest recession indicator of all is the gap between ten-year and three-month Treasury yields. Typically this is positive, with long-term yields higher than short-term ones (as investors demand a higher return to lock up their money for longer). The gap has turned negative (meaning investors expect imminent and sustained rate cuts) only nine times in the past half-century. Eight were followed by recessions. The ninth negative spell started last October and continues today. As Fed officials bring the economy in to land, the most reliable part of the dashboard is flashing red.
That was last week’s Economist. Now comes this week’s:
And The Economist writes:
Inflation will be harder to bring down than markets think
Investors are betting on good times. The likelier prospect is turbulence
Given how woefully stock and bond portfolios have performed over the past year or so, you may not have noticed that financial markets are floating high on optimism. Yet there is no other way to describe today’s investors, who since the autumn have increasingly bet that inflation, the world economy’s biggest problem, will fall away without much fuss. The result, many think, will be cuts in interest rates towards the end of 2023, which will help the world’s major economies—and most importantly America—avoid a recession. Investors are pricing stocks for a Goldilocks economy in which companies’ profits grow healthily while the cost of capital falls.
In anticipation of this welcome turn of events the s&p 500 index of American stocks has risen by nearly 8% since the start of the year. Companies are valued at about 18 times their forward earnings—low by post-pandemic standards, but at the high end of the range that prevailed between 2002 and 2019. And in 2024 those earnings are expected to surge by almost 10%.
It is not just American markets that have jumped. European stocks have risen even more, thanks partly to a warm winter that has curbed energy prices. Money has poured into emerging economies, which are enjoying the twin blessings of China abandoning its zero-covid policy and a cheaper dollar, the result of expectations of looser monetary policy in America.
This is a rosy picture. Unfortunately, as we explain this week, it is probably misguided. The world’s battle with inflation is far from over. And that means markets could be in for a nasty correction.
For a sign of what has got investors’ hopes up, look at America’s latest consumer-price figures, released on February 14th. They showed less inflation over the three months to January than at any time since the start of 2021. Many of the factors which first caused inflation to take off have dissipated. Global supply chains are no longer overwhelmed by surging demand for goods, nor disrupted by the pandemic. As demand for garden furniture and games consoles has cooled, goods prices are falling and there is a glut of microchips. The oil price is lower today than it was before Russia invaded Ukraine a year ago. The picture of falling inflation is repeated around the world: the headline rate is falling in 25 of the 36 mainly rich countries in the oecd.
Yet fluctuations in headline inflation often mask the underlying trend. Look into the details, and it is easy to see that the inflation problem is not fixed. America’s “core” prices, which exclude volatile food and energy, grew at an annualised pace of 4.6% over the past three months, and have started gently accelerating. The main source of inflation is now the services sector, which is more exposed to labour costs. In America, Britain, Canada and New Zealand wage growth is still much higher than is consistent with the 2% inflation targets of their respective central banks; pay growth is lower in the euro area, but rising in important economies such as Spain.
That should not be a surprise, given the strength of labour markets. Six of the g7 group of big rich countries enjoy an unemployment rate at or close to the lowest seen this century. America’s is the lowest it has been since 1969. It is hard to see how underlying inflation can dissipate while labour markets stay so tight. They are keeping many economies on course for inflation that does not fall below 3-5% or so. That would be less scary than the experience of the past two years. But it would be a big problem for central bankers, who are judged against their targets. It would also blow a hole in investors’ optimistic vision.
Whatever happens next, market turbulence seems likely. In recent weeks bond investors have begun moving towards a prediction that central banks do not cut interest rates, but instead keep them high. It is conceivable—just—that rates stay high without seriously denting the economy, while inflation continues to fall. If that happens, markets would be buoyed by robust economic growth. Yet persistently higher rates would inflict losses on bond investors, and continuing elevated risk-free returns would make it harder to justify stocks trading at a large multiple of their earnings.
It is far more likely, however, that high rates will hurt the economy. In the modern era central banks have been bad at pulling off “soft landings”, in which they complete a cycle of interest-rate rises without an ensuing recession. History is full of examples of investors wrongly anticipating strong growth towards the end of a bout of monetary tightening, only for a downturn to strike. That has been true even in conditions that are less inflationary than today’s. Were America the only economy to enter recession, much of the rest of the world would still be dragged down, especially if a flight to safety strengthened the dollar.
There is also the possibility that central banks, faced with a stubborn inflation problem, do not have the stomach to tolerate a recession. Instead, they might allow inflation to run a little above their targets. In the short run that would bring an economic sugar rush. It might also bring benefits in the longer run: eventually interest rates would settle higher on account of higher inflation, keeping them safely away from zero and giving central banks more monetary ammunition during the next recession. For this reason, many economists think the ideal inflation target is above 2%.
Yet managing such a regime shift without wreaking havoc would be an enormous task for central banks. They have spent the past year emphasising their commitment to their current targets, often set by lawmakers. Ditching one regime and establishing another would be a once-in-a-generation policymaking challenge. Decisiveness would be key; in the 1970s a lack of clarity about the goals of monetary policy led to wild swings in the economy, hurting the public and investors alike.
Back to Earth
So far central bankers in the rich world are showing no signs of reversing course. But even if inflation falls or they give up fighting it, policymakers are unlikely to execute a flawless pivot. Whether it is because rates stay high, recession strikes or policy enters a messy period of transition, investors have set themselves up for disappointment.
To repeat the conclusion: “investors have set themselves up for disappointment.”
I personally tend to agree with the Economist. Look at the chart for the S&P500 for this year so far. It’s definitely been volatile.
Today was brutal.
Going forward it might be good to have a more balanced portfolio. I am short VGT, GE and INTC. I will probably short more.
My biggest equity long positions are NVDA, TSLA, AAPL, GOOGL and MSFT. They’re all up this year.
But tomorrow brings a new day. If I hit a decent down-the-line backhand, I may feel empowered. I did hit a decent down-the-line forehand today, which clinched that set for me. But not the value of my portfolio, which cratered.
Sadly there’s not much correlation between my tennis game and my stock picking game.
But, it is an amazing world. You can earn 4.99% on a six-month U.S. treasury — which is a lot more satisfying than a slap in the belly with a cold fish. (Australian expression.)
Shameless
The New York Times rants about inflation.
Yet, this week, the paper with “All The News That’s Fit To Print” jacked up its newsstand price from $3 to $4.
That’s 33% inflation.
Neat cartoons
The husband is priceless.
That’s it for tonight. See you soon. — Harry Newton
