Economics Journal: Hard Landing Cometh
On watch for a private equity "shock" event to officially make the narrative hand-off from "soft landing" to "hard landing".
Soft Landing Fantasy
In a recent note Ned Davis Research strategist Joe Kalish had this to say about the probability of the Fed engineering a soft landing:
“Of the ten prior tightening cycles, I would argue that four did not end in recession: 1963-65, 1987-89, 1994-95, and 2015-18. The 1990 recession was the result of an oil price shock due to the Iran-Iraq war, and the 2020 recession was due to the pandemic. Neither was the direct result of tighter monetary policy. So maybe a soft landing is not as difficult to achieve as is commonly believed.”
There are two problems with this analysis: 1) the 3y/10y UST curve has been deeply and persistently inverted for almost a year, and 2) the Conference Board LEI has been deeply negative for over 6 months, neither of which came close to happening in the four prior “soft landings” cited by Kalish.
The bottom line remains: Unless the Fed gives up on its 2% inflation target (as indicated by a sustained bear steepening of the UST curve), a soft landing is not possible in a high-inflation economy driven by excess demand. The Fed has made it abundantly clear that it understands this, and in my opinion the deeply and persistently inverted state of the yield curve and a deeply negative Conference Board LEI confirm. As such, an economic contraction that drives the unemployment rate up to at least 4.5%1 is a matter of when not if.
4Q23 Recession Start Date
I continue to be stupefied by the economy. As outlined in a July 9 post, I came into 2023 with the view that a recession was either underway or imminent based on what I thought to be a robust analysis of the cross-asset evidence available at the time. But that analysis quickly proved less than “robust”, with economic data and risk markets surprising to the upside. However, once SVB hit and the UST curve moved into a state that has historically preceded rate cuts ahead of a hard economic landing, I concluded that my analysis coming into the year was in fact right and it was the risky asset market that overreacted to a blip in economic data. But now I’m right back to square one with the 2-year UST note yield hovering just below its highs and sticking there despite what appears to be softening inflation data, and an economy that continues to perform more in line with the “higher for longer” thesis that a recession is unlikely to hit until well into 2024. It’s baffling, to say the least.
But this is why I have my Economics “Team”. I cannot do it alone. And now more than ever I am relying on those I trust to break the tie between what I see in my own cross-asset analysis that says recession cometh + SPX bear market intact, and still-resilient headline data (principally the labor market).
The WOTE’s Economics “Team”
Leaning on publicly available information from three key members of my Economics “Team” - The Kitty, 42 Macro, and Eric Basmajian - a 4Q23 recession start date appears to sit at the center of the Venn diagram:
Eric’s process points to the recessionary process as currently underway, with the labor market the key marker holding out from officially confirming.
42 Macro says 4Q23 to 1Q24.
And The Kitty says 3Q23 to 4Q23.
42 Macro
The Kitty
The WOTE
All of the above against the backdrop of my own cross-asset analysis - lack of a bear market-ending 50dma thrust + deeply inverted 3y/10y UST curve + deeply negative Conference Board LEI - tells me the equity market is extraordinarily offsides banking on a “soft landing”. And not only is the market offsides with regard to recession, it is now just offsides generally, with extremely bullish positioning and increasing amounts of VOL selling speculation. The ingredients are very much in place for a true crash to 3000-3500 by that September/October time frame.
Now, the alternative view here remains the “higher for longer” scenario where the Fed backs off after hiking in July to a lower bound Fed Funds of 525, the economy and inflation reaccelerate, and the Fed resumes hiking later this year and into 2024. In my opinion, the key indicator to watch for this scenario is the bear steepener. If the long-end of the UST curve starts leading the entire curve higher as a result of rising inflation expectations (i.e. as measured by TIPS break-evens), that would tell me the Fed is in the process of losing control of the inflation narrative. Given the fact FED Chair Powell’s legacy is on the line, I believe he will continue to respond to the lagging data in front of him and resume hiking in this scenario.
Regardless, from an equity market perspective the outlook is exceedingly poor in any scenario that does not involve the Fed giving up on its 2% inflation target, as indicated by them not responding to a bear steepener with more rate hikes.
Eric Basmajian
Eric gets a dedicated section in this write-up due to the meaty Twitter thread he put together this morning on the current state of nominal growth and FED policy. Eric’s highly systematic process fits perfectly with 42 Macro, The Kitty, and my own cross-asset analysis, and his conclusion that the recessionary process is underway is highly valuable information beyond trying to nail a specific start date. My read of his conclusion is that the US economy is in what ECRI calls the “window of vulnerability” - a window that allows for an outside “shock” to ultimately crack the labor market and force government officials and financial market participants to formally acknowledge that a recession is in fact underway. I believe a “shock” emanating from private equity is potentially in train, but before I delve into that, below is Eric’s thread from this morning as well as a recent interview he gave
Private Equity
As mentioned above, I believe there is a good chance of a “surprising” shock event that emanates from private equity. The issues in commercial real estate are well-documented and frankly immunized by the Fed’s balance sheet, but PE is not getting its due coverage. Just in the last two weeks I’ve had two entirely independent conversations with folks in and around the PE industry, both saying the same thing: private equity is SCARED. Much of PE’s debt is floating rate and now costs in the range of 10%; and the industry has been betting against the Fed, holding off on exits and business improvements in anticipation of lower rates. Two key quotes from one in response to the recent FT article on NAV financing:
“…PE profitability will be structurally exposed for those funds that ran on low interest financing to drive asset prices up over time for a successful exit (without any improvements in the underlying business). Tide’s going out.”
“Taking high interest dividend re-caps on floating rate loans because you can’t sell the levered up PortCos strikes me as an all or nothing bet that interest rates are going to collapse before internal problems become public knowledge.”
I will be shocked if the “soft landing” narrative continues past August. Powell may give it one more push at next week’s FOMC, but if the above analysis is correct, the “hard landing” narrative should take over here soon.
Please see The Outlook from March 31 for more of my thoughts on where the unemployment rate is likely to rise to.