No, I'm Not Turning Soft

As everyone gushes over the +2.4% annualized real GDP growth spurt in Q2, what goes unreported is that this is precisely what the number was in the quarters preceding the 2001 recession (2000Q4) and the 2007-09 recession (2007Q3).

The average growth rate for the quarter the recession begins shows real GDP actually expanding at a +2% annual rate (back to the early 1970s). The very same quarter the recession begins! So the market has been trained by Wall Street economists, the Fed and the media to focus on lagging and contemporaneous indicators. The lags from the initial rate hikes, the time the yield curve inverts, the time from the peak in the LEI and from the time the NY Fed recession model pierces the 70% threshold, only then they say the recession is staring us in the face. We are still well within the ranges of the past for each indicator. The lags can be long, as we saw in 2007 when there were offsetting factors at play and back then it was about the lingering effects of mortgage-equity withdrawal and cash-out refinancings that bolstered household spending power. This time, it has been the lingering effects of the “excess savings” and the impact of the Biden fiscal package at play... but as I have said and keep on saying, there is nothing more powerful than interest rates when it comes to economic activity, with lags, and asset valuations.

I was asked all through 2007 when I was at Merrill, “where is this recession you’ve been calling for, Rosenberg?” and the same salespeople on the equity desk who refused to take me to see clients that year became my best friends in 2008 (they know who they are). I almost got fired twice for my calls in 2007 but my Institutional Investor All-Star rankings saved my skin (my boss at the time ended up doing a 360 external consultant review on my contribution to Mother Merrill... money well spent, I am sure... to only then offer me the dual role of Chief Economist and Strategist in early 2009... but for me, it was time to come home after a long seven-year absence from my family). In the summer of 2007, I had a CIO at a famed Houston-based mutual fund storm out of a meeting I gave and he scolded me as he exited the boardroom (“you have no clue about the housing market or the economy for that matter”). I had the head of Merrill’s fixed-income sales physically throw my presentation package at me at an internal meeting and told me in front of about 30 people that I was the worst Fed-watcher he ever saw... one time, when I was walking around the trading floor, this guy called me over and handed me the phone and I thought it was a client but it was his wife on the line, and she said: “my husband asked me to ask you why it is you are so useless.” So, you think I haven’t seen all this before? Even today, we have an inbox for client queries and comments here at Rosenberg Research and let me tell you — much the same. I have one client, who shall remain nameless obviously, who hurls insults at me every single day. Our bullish calls on Japan, Mexico, India and, more recently, Canada, have been overshadowed by our desire not to be involved with the most overvalued stock market on the planet.

And while we had a tough year in 2022 on the bond call, since the yield peak last October, you have made money in Treasuries and they do provide a ballast in the portfolio but we are in a moment of time where risk-adjusted returns and capital preservation psychology are viewed as arcane relics to be ignored. Just go all-in on the Nasdaq 100, right? (Oh, how short the memories are, considering this red-hot index in 2023 was turned into an ice-cold decline of more than -30% in 2022.)

Go figure. It’s called human nature. Jacob, my middle son who doubles as my COO and many of you know, told me the other day that the “hate mail” I have received on social media these past few weeks has been “off the charts.” Use that information any way you want — but it is a contrarian indicator. I was called the “skunk at the picnic” and the “class clown” in 2007 (and in 2000 as well when I was called a “Luddite” because I didn’t understand how the Internet defeated the business cycle), so all I can say is that this isn’t the first time I have been early on the call, and certainly not the first time to face the wrath of “haters” out there. The impatience and tempestuousness out there do not surprise me, either, having called the markets and the economy for nearly 40 years.

This was the title of a Cleveland Fed report in November 1989, just ahead of the 1990 recession:

How Soft a Landing?

Here was a Market Insight column from December 2000 (the recession began three months later):

Making A Soft Landing Even Softer

And this was from September 2007, two months before the onset of The Global Financial Crisis published by the Dallas Fed and picked up by Reuters:

U.S. economy on track for soft landing -Dallas Fed

“WASHINGTON, Sept 26 (Reuters) - U.S. inflation pressures are easing and the economy should manage a soft landing, the Federal Reserve Bank of Dallas said on Wednesday.

'The latest data reinforce the impression of an economy in which growth remains moderate and inflationary pressures are likely to continue to subside,' it said in a national economic review written by senior Dallas Fed staff economist Tao Wu.”

Indeed, at the time of the article, it was true that growth “remains moderate.” But here’s the rub: it did not end up “remaining” moderate, now did it? Remember — the NY Fed recession model only crossed over the 70% “never turn back” level last November! It is now at 97%!! This model assesses recession probabilities over the next TWELVE months... not TWELVE days, not TWELVE weeks, but TWELVE months. Capiche, paisano? 

Let’s see how things cook this fall before making any bold declarations that the business cycle has been repealed, which is really the tale the “soft landing” enthusiasts have been spinning. 

The positive reading in real GDP growth in Q2 really was no surprise and was flagged by the Atlanta Fed Nowcast model ages ago. All of a sudden, we get the +2.4% GDP print and it’s “look ma, no recession.” Right — to which I say... “not yet!” The smugness and complacency are ubiquitous.

The positive GDP reading was also flashed ahead of time by the Conference Board’s index of coincident economic indicators (payrolls, incomes). In Q2, the coincident index was up at a +0.8% annual rate but we had a massive divergence with the leading index which contracted at a -9.3% annual rate. A divergence that is notable and important in terms of where we are heading, not where we are (or have been).

Divergences like we just saw in Q2 have only happened in the past at major turning points in the economic cycle:

In 2019Q4, before COVID-19 reared its ugly head, the coincident index was up +0.3% at an annual rate while the leading indicator contracted -3.3%. This was why I was calling for a downturn whether or not the pandemic was coming our way (and why Powell was scrambling to cut rates in the second half of that year).

In 2007Q4, the coincident index rose +0.6% and that emboldened the “soft landing” narrative at the time, as is the case presently, but the divergence was apparent in that the leading indicator had collapsed -8% (the latest decline is even greater than that!).

Again, in 2000Q4, right ahead of that recession that nobody saw coming, the coincident index rose +0.6% while the LEI was down -7.6%. Tell me, since we know what happened with the benefit of history: did you want to pay attention to this divergence or pay heed to the majority of economists and market pundits and either ignore it or dismiss it out of hand? That question can be considered rhetorical.

Then in 1990Q2, we had the index of coincident indicators expanding +2% but not validated by the -2% slide in the leading index and what do you know? The recession began the very next quarter. Another one that crept up on the unsuspecting crowd.

We now dig deeper into the historical record — in 1979Q4, just ahead of the back-to-back recessions of the early 1980s, the coincident indicator expanded +0.6% at the very same time the LEI plunged -9.4%. This divergence looks a lot like what we have on our hands right now. We think that everyone knew that Volcker was intent on generating a recession, but that is hardly the case. The only economist calling for a downturn at the time was my pal, Gary Shilling, the first chief economist at my alma mater Merrill Lynch... and he was summarily fired by Donald Regan for daring to publish a recession forecast.

The recession of the early 1970s began in the fourth quarter of 1973 — what should have tipped off the crowd at the time was that in the third quarter of that year, just ahead of the downturn, the coincident index uptick of +2.6% was not ratified by the -6.0% slump in the leading index. These divergences, folks, are really important, and lamenting why the recession hasn’t started yet (and for reasons we know) is a colossal waste of time. That the stock market has rallied big-time is also explained by the fact that the onset of fundamental bear markets are always characterized by a sharp fall from the initial peak, a reflexive rally back towards the highs on soft-landing hopes and signs that the Fed is done tightening or is actually easing policy, and then the long and drawn-out decline to the lows. There is nothing here that we haven’t seen before. My mistake this year was not identifying the reflexive rally, but this is still a bear market rally nonetheless. There is nothing I see that tells me we are into a fundamentally-based fresh bull market. Resolve is clearly being tested, and this isn’t the first time nor will it be the last time. There will be plenty of opportunities to get back in and more than just for a multi-month trade in the future. I’ve been around the track enough times to know that.

Finally, in 1969Q3, just ahead of that recession, once again, the trigger for the “red flag” came from the glaring divergence between the index of coincident indicators (+4.1%) and the LEI (-4.1%). As much as an iron-clad warning shot as there is.