With the year-to-date squeeze higher in equity markets on the heels of better inflation news and resilient employment stats, it makes sense to assess what the data is telling us. Larry Summers, speaking from Davos earlier this week had this equivocation: “A soft landing is the triumph of hope over experience, but sometimes hope does triumph over experience.” In other words, the one economist who never lacks for an opinion and has been calling for an ugly recession is currently a bit flummoxed. I can sympathize. Some recent data has been better from both a growth and disinflation perspective and given the way the lowest quality stocks and the far-end of the risk spectrum (like bitcoin) have rallied, we know bearishly positioned market participants have been capitulating. I think there are two potential scenarios and I have enumerated them below.

In short, I continue to lean toward the recession in 2023 camp and one that will have a meaningful impact on corporate profitability broadly. I also will repeat my core thesis: The Fed can destroy demand which temporarily balances supply and demand, but we face structural supply problems in the form of labor and energy that are secular, and I believe those supply constraints will pressure inflation in a way that will make it very difficult for the Fed to cut rates to the extent fixed income markets are currently pricing.

Reasons to Expect a Soft-Landing Economic Scenario

We have reduced inflation significantly without crushing unemployment. More than anything, it is this dynamic that has surprised the bear camp. Could it be possible that we have a scenario where we continue to see real wage growth amid falling headline inflation? Is it possible that housing costs come down, that gasoline settles at these lower levels, that autos move further into oversupply driving prices lower, while coincidentally, workers continue to get a bigger piece of the profit pie? This is the ideal scenario for the overall economy. Real wage growth and low unemployment would drive consumption and allow us to avoid or even escape the predictable consumer credit cycle that should occur when interest rates / cost of capital have risen so dramatically and the economy slows. Is that scenario possible? The answer is probably not and it would be, to my knowledge, unprecedented.  Wages are likely too big a piece of the overall inflation story to have growth in one and not the other.

That said, unlike previous cycles where wage growth was driven by higher consumer costs begetting higher wage demand, now we see workers demanding more money simply because they can? They can because the employer is now less inclined to extend their supply chains or try to go out and hire someone else when available talent is so scarce.

The risk of creating the dreaded wage price spiral might be lower when wage demands stem from employee negotiating leverage versus the need to offset higher cost of living. Consider that in the latter scenario, costs of production are also pushing higher adding to the amount of costs the employer/producer has to pass through. In the former scenario, the employer/producer only has to pass through the cost of higher wages and enjoys margin relief from disinflation elsewhere.

Longer-term, any economist will tell you 3.5% unemployment is inconsistent with the Fed’s 2% wage target. Ultimately, the solution to wage inflation comes from investment that drives higher productivity growth. To believe that we can overcome labor market tightness without a long stagflationary period, one has to believe that we will see a sharp improvement in labor productivity which has grown well below the post-war trend over the last decade.  

Soft Landing Equity Market Implications

As long as the trends of moderate real growth and falling inflation stay in place, this market will continue to rally.

However, if we see inflation re-accelerate, we’re going to see a whole lot of volatility upside in both equities and fixed income where markets are pricing in a recession and significant rate cutting starting in late 2023. The more likely scenario is that the slowdown consensus expressed in bond world is at least directionally right.

Reasons to Expect a Recessionary Economic Scenario

The list unfortunately is a long one so for brevity’s sake, we go to bullets.

• Leading Economic Indicators

  • Home sales and manufacturing orders are deep in contraction mode.

• The yield curve inversion

  • No recession with this level of inversion across the curve would be unprecedented.

• M2, Fed liquidity or Bank Reserves correlate to global equity markets

  • The correlation to the above-three measures of liquidity and the S&P 500 are all high and all of these measures are quite predictably going to continue to trend lower.

• Valuations while profit margins are near all-time highs.

  • Operating margins correlate to ISM New Orders and the trend of the latter is accelerating into contraction.

• Consumer savings rate is nearing historical lows as credit costs rise

• Corporate and consumer credit costs reset over time. One reason long and variable lags to monetary policy exist is because cost of capital increases over time as debt resets higher over months and years.

• Falling credit availability

• Credit deterioration

• The recent trends in automotive subprime and rising card delinquency are rapidly becoming worrisome.

Recessionary Equity Market Scenario

Equity markets are not priced for the kind of sharply falling earning estimates that come in a recession. We are currently bouncing around the 4000 level which is more than 20x where earnings will likely settle out. The depth of the weakness in equity markets will likely be determined by the outlook for inflation and how much slack does the Fed have to start cutting rates again. The other determinant will be credit: consumer, corporate and government. It is hard for me to imagine that many years of virtually free money ended by doubling and tripling of credit costs doesn’t lead to some important dislocations.

One of my favorite market observers is Bridgewater Associates veteran Bob Elliott who has called the recent spate of optimism “Transitory Goldilocks”. Earlier this week, he wrote, “This extended inflationary cycle is very different from any of the cycles that investors today have experienced in their lifetimes. It is also very different than any cycle we have experienced in decades. The result is that there is still a great deal of uncertainty about how it may play out. For years, holding cash was not a useful alternative asset because it was so poorly yielding. In this cycle, it is worth recognizing that cash may also be one of the better assets to hold. It allows investors to reduce their risk while enjoying modest return.”

I could not agree more.

 
For more from Tim, follow his podcast The Weekly Bull and Bear wherever you listen to your podcast or read his weekly blog posts here.

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