2023-08-22 07:13:09 ET
Summary
- Many believe the Federal Reserve will achieve a 'soft landing' despite a 525bps hike in the Fed Funds rate, but this optimism is misplaced.
- Changes in monetary policy have a significant lag before fully affecting the economy, suggesting a recession in early 2024.
- Economic indicators, such as the LEI, which has now declined for 16 straight months, are signaling a likely economic contraction is dead ahead.
- Most importantly, the headwinds facing the consumer are substantial, and excess personal savings has largely been exhausted.
- Why a consumer-led recession is very likely in the quarters ahead and how I am positioning my portfolio for the upcoming market selloff is discussed in the paragraphs below.
Overconfidence precedes carelessness ." - Toba Beta
The majority of economic pundits and investors continue to believe that the Federal Reserve will achieve its almost mystical at this point ' soft landing '. They reason that monetary tightening began nearly a year and a half ago in March of 2022. And despite a 525bps rise in the Fed Funds rate over that time, the economy continues to appear to be humming along with two percent GDP growth in the first quarter of this year, which was topped by 2.4% GDP growth in the second quarter. The Atlanta Fed's GDPNow even has nearly six percent GDP growth projected for the third quarter of 2023.
However, I continue to believe this optimism is deeply misplaced for several key reasons. The first of which is that changes in monetary policy ALWAYS have a significant lag before they are fully felt throughout the economy and the markets.
This can be seen in the graph above. On average, past recessions happened nearly two years after the first stages of more restrictive monetary tightening by the central bank. That would put the country in recession early in 2024 if historical norms are followed.
A likely economic contraction is also being confirmed by a variety of economic readings starting with The Conference Board's Leading Economic Indicators or LEI. They fell by .4% month-over-month in July. This makes 16 straight months of decline from the LEI.
The Conference Board
This is the longest consecutive months of declines since the period from June 2007 to April 2008 which preceded the Lehman debacle in September of 2008, which precipitated the greatest financial crisis since the Great Depression. Bear Sterns failed in March of that year.
Atlanta Fed GDPNow
I also would take the current GDPNow Q3 GDP forecast with a huge grain of salt as it flies directly against the Blue-Chip Consensus projections of quarterly economic growth in this quarter. This is one of the biggest divergences I have ever seen from these sources. Goldman Sach's current estimates for GDP growth for Q3 is 2.2%, in line with the first two quarters of the year.
There are three things that could push the economy into a recession and equities into a likely bear market. The first is a geopolitical black swan. A dirty bomb going off in Ukraine, China invading Taiwan, or the complete collapse of the Chinese property market are good examples. Black Swans are always unlikely, and their odds are impossible to calculate accurately.
The other two potential causes of recession are directly related to the monetary tightening of the past 17 months and the lag before that fully hits the economy. The first is the accelerating deterioration in the commercial real estate market triggering substantial downstream impacts on the larger economy. I have written about this topic several times over the past month ( I , II , III ) so I won't further deliberate on this subject in this article.
However, the most likely cause of the next recession is that the consumer pulls back on spending enough to cause an economic contraction. Given the consumer accounts for some 70% of economic activity in the U.S. and the multiple headwinds the American consumer is currently facing, this seems the most likely trigger that pushes the country into a recession, perhaps a significant one, by the first half of 2024, if not sooner.
Inflation is up approximately 17% from the start of 2021. Although surging prices have moderated significantly in recent months, the average consumer has loss just over three percent of their buying power to inflation over that time span. Two things have allowed consumer spending to hold its own. The first is a robust jobs market since the pandemic lockdowns ended. The second is the massive amount of savings built up thanks to the humongous covid related stimulus funding by the federal government.
MRINetwork
However, cracks are starting to appear in the jobs markets. According to July BLS Jobs Report , the economy created some 187,000 net positions during last month. June's jobs numbers were also revised down from 209,000 to 185,000. As can be seen in the chart above, this is a significant slowdown in monthly jobs created from a year ago as the economy has now recovered all the jobs lost during the pandemic and associated lockdowns. More concerning is that full time positions fell by nearly 600,000 in July, which was made up for in the net numbers by a huge surge in part-time positions. This kind of shift typically takes place in a prelude to recession historically.
Consumer savings built up during the pandemic and through the largess of various stimulus programs have also largely wound down. The personal savings rate has plunged in recent quarters, after reaching nearly 17% in 2020 and 12% in 2021. Through June of this year, Americans had saved 3.8% of their income cumulatively through the prior 12 months. This is the lowest personal savings rate since 2008. That rate was 7.3% prior to the pandemic, it should be noted.
In addition, the Head of Quantitative Research at JPMorgan Chase & Co. ( JPM ) just came out with this statement :
Our estimate of excess savings for US households when adjusting for inflation is now fully exhausted from a 2021 high of $2.1 trillion, with risk of widening imbalance if outlays accelerate. And while there are still elevated levels of household liquidity across cash assets, estimated at $1.4 trillion when adjusted for inflation, that too is at risk of getting fully depleted by May of 2024 "
Given these headwinds, it is hard to see how the consumer holds up and doesn't significantly decrease spending in the months and quarters ahead. This will likely push the economy into recession no later than the first half of 2024. As the market narrative shifts from the current consensus around a soft landing to a hard one, equities will decline, perhaps substantially given the average peak to trough move of the S&P 500 during post WWII recessions has been 35%.
Given this outlook, my portfolio remains very conservatively positioned, awaiting lower entry points. Approximately half is in short term treasuries yielding nearly 5.5%. 40% of my funds are within covered call holdings on reasonable valued names, with rock solid balance sheets for the most part. About five percent will remain in cash.
I am also making small, short bets in overvalued stocks via long-dated out of the money bear put spreads . I recently described one of these trades around Apple ( AAPL ) and another on Tesla, Inc. ( TSLA ). Both are already nicely in the money thanks to the fall in these equities so far here in August.
I have also been building larger long-dated bear put spread positions in both the SPDR® S&P 500 ETF Trust ( SPY ) and the Invesco QQQ Trust ETF ( QQQ ) that will pay eight to 12 to 1 if these indexes lose 15% to 20% of their value over the next 10 to 13 months.
And that is how I am ' hunkering down ' in front of the approaching economic storm.
Eyes held high in pride are less able to see uneven ground ahead. "? Timothy Zahn
For further details see:
The 'Soft Landing' Fallacy