When we look at the history of inflation, the history of Federal Reserve policy, and recent economic data, it is easy to conclude that a recession is either at hand, or at least on the horizon. But before we explain why we believe a recession is likely, it is also important to point out that the next recession should be different than those recently experienced, and hopefully more manageable. The main reason for this optimism is the healthy financial condition of the US banking sector. Just the opposite was true of the 2008 financial crisis and the severely weakened state of the US banking system was a major risk for the overall economy. Today, not only are the banks’ balance sheets in good condition, but we find that household balance sheets are also in fine shape. And even though corporate debt has been on the rise, corporate America is not overextended. This is important since it suggests that any recession should be relatively short and contained.
The one area of concern is the federal government where stimulus packages have added trillions of dollars to the national debt in a short period of time. Congress approved the $2 trillion CARES Act in March 2020, which was followed by a $900 billion Covid-19 relief package in December 2020. Some of this was necessary. During the mandatory shut down of the economy very few Americans could go back to work and collect a paycheck. Businesses were forced to remain closed. Plus, the mandatory Covid vaccinations and tests were paid for by the US government to prevent the spread of the virus.
This was less true in 2021, yet in March 2021 President Biden’s Build Back Better plan became the American Rescue Plan Act of 2021 which was an additional $1.9 trillion stimulus package. In total, the national debt increased by nearly $5 trillion, or nearly 25% of GDP, in a short 12-month period. As of October, the US debt stands at $31.12 trillion, which means the federal debt load is currently more than 120% of GDP — estimated to be $25.7 trillion at the end of the third quarter.
Unfortunately, interest rates are now on the rise and the cost of carrying this debt will become ever more costly. And the US is not the only country that increased its national debt during the pandemic. This was true of many countries impacted by Covid-19. In short, if there is a weakness, or a problem in the next recession it could be centered in the sovereign debt markets.
Inflation and Recession
We have written in previous weeklies that whenever inflation has been above average (3.5%), an economic recession has followed. More worrisome is the fact that the last time inflation was as high as it is in the current cycle, or a standard deviation above the norm (6.2%), the economy suffered a series of recessions. This is best represented by the 1968-1982 era. In the current cycle, the Federal Reserve has been very tardy in addressing inflation and as a result, a recession has been delayed. But this may only make inflation more difficult to tame today and keep interest rates higher for longer than expected. Historically, the fed funds rate rose ahead of, or in line with, inflation. See page 3. In our view, this is why it is imperative that the Federal Reserve Board be an independent, nonpolitical body. Raising interest rates during a presidential election year, for example, might be a difficult policy to follow; but failure to do so could be debilitating for many American households in the longer run.
Inflation is deceptive because it silently diminishes the purchasing power of households. Some economists worry that hourly earnings rose 0.6% in November; however, average weekly earnings rose 4.9% YOY in November while inflation rose 7.8% YOY in October. In short, inflation has exceeded the growth in wages for most of the last 18 months. Rising wages are not a source of inflation in our view. In fact, the fact that real hourly earnings are negative on a year-over-year basis is another indication a recession is ahead. See page 4.
Personal income has been in a steady uptrend for the last two years, but due to soaring inflation, just the opposite is true of disposable income or real disposable income. As a result, as of October, personal consumption expenditures have been exceeding income for 19 straight months. It is an unsustainable situation. See page 5. Not surprisingly, the savings rate declined to 2.3% in November, which is the lowest rate recorded by the BLS since the 2.1% reported in July 2005. However, in 2005, the savings rate quickly rebounded to 2.6% in August. We doubt that will happen in this cycle. Also noteworthy is the fact that the unemployment rate was unchanged in November at 3.7%, a historically low number. This gives the appearance of a strong economy, but we believe it is an economy of the haves and have-nots. Middle America is struggling. See page 6.
This combination of data suggests to us that the Federal Reserve will continue to raise interest rates in order to battle the now-ingrained inflation seen in this cycle. As a result, the economy is apt to slip into a recession in 2023. In recent months the Treasury yield curve has become inverted which is a classic financial sign of a recession on the horizon. See page 8.
Inflation and Equity Performance
We often look at history to see how stocks have performed whenever inflation has remained above average for a lengthy period of time. The most instructive period of time would be the 1968-to-1982-time frame when headline CPI remained consistently above 4%. The chart on page 9 is a quarterly chart and only records the S&P 500 index at the end of each quarter. But what it shows is that the S&P 500 Composite closed at 103.86 in December 1968 and closed at 102.09 in March 1980. In other words, the index was in a broad trading range and made no upward progress for over eleven years — or until inflation was brought back under control.
The experience of this previous era of inflation is why we believe the Fed may need to keep interest rates higher for longer than the consensus expects. The failure to get inflation under control in the first tightening cycle could result in multiple Fed tightening cycles — and recessions – like what was seen in the 1968 to 1982 period.
There are some markets that are already warning of a recession. The weakness in crude oil prices implies that traders expect energy demand to weaken as global economies slide into a recession. The decline in the 10-year Treasury bond yield represents a flight to safety in long-duration US Treasury bonds. See page 10. For all of these reasons, we believe the best strategy is to focus on recession resistance companies or areas of the economy that represent “necessities” to households, corporations, and governments. Sectors that represent these characteristics include energy, utilities, food, staples, and aerospace. See page 16.
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