Back In Time
Last week, HAI detailed an alternative, lower odds “inflationary fire” scenario. Rather than break down, markets could potentially crack up. Current levels of massive government debt, deficits, interest expenses, and complicated questions over the efficacy of the monetary policy brake to fight inflation at current levels of debt certainly throw a different and challenging new dynamic into the mix. These differences could materially change market behavior if market prices are increasingly derived from expectations for government sanctioned inflation and potentially severe currency debasement.
We need to monitor that possibility and its expected market behavior very closely. As mentioned last week, these dynamics could ultimately result in a path towards the highly inflationary and ultimately catastrophic crack-up boom described by the Austrian school of economics.
In HAI’s view, we are very likely looking at either the early stages of just such an inflationary fire scenario (lower odds) or the more likely scenario in which this stock market train has a next-stop rendezvous with recessionary ice. HAI’s view aside, the most popular narrative currently captivating market participants is that of the “soft-landing” in which inflation falls to target, the Fed can ease policy, the business cycle is miraculously refreshed, and a new long-term bull market is born. In other words, this market is thinking all aboard! The stock market train is the gravy train, and it’s now presumed to be a non-stop express to easy riches.
This week, Let’s take a moment to hop into Emmett “Doc” Brown’s DeLorean, supercharge the flex capacitor to 1.21 “gigawatts,” accelerate to 88 mph, and do some time traveling to examine “soft-landing” narratives past. Then we’ll jump “back to the future” to apply lessons learned to our modern market moment—lessons that might help us safely navigate the uncertain seas ahead. So, strap in. First stop: 1973!
In September of that year, Lafayette College Professor and top economic forecaster at the U.S. Treasury Herman I. Liebling popularized the term “soft landing.” He forecasted one in a New York Times article titled, “Economists See a ‘Soft Landing’ When Boom Ends.” In the article, Liebling pointed to “strengths” in the economy that “were absent in earlier episodes” when monetary policy restraint had turned booms to busts.
The gear-buckling touchdown that swiftly followed, beginning in that very same Q4 of 1973, didn’t relent until 1975. That hard landing wasn’t the featherbed conclusion Liebling expected. Highlights from the recession that followed include a 3.2% drop in GDP, an unemployment rate that spiked to 9%, and a 46% real decline in the S&P 500.
In Q3 of 1973, just ahead of the downturn, the soft-landing narrative appeared well supported by the Conference Board’s coincident index of real time economic activity running positive at 2.6%. However, the prospect of a soft landing was decidedly contradicted by the 6.0% drop in the Conference Board’s Leading Economic Index (LEI). And the thing about leading indicators is that they do lead. When it came to warning of future events, the forward-looking LEI was prescient.
Following the 1973-1975 recession, markets recovered only modestly before the economy was compromised and once again became mired in inflation. By late 1978, after the Fed had raised the fed funds rate from 5.0% to 8.5%, concerns over another economic downturn were starting to bubble up again. However, in September of 1978 the Desert Sun newspaper ran the headline, “Soft Landing Economy Seen.” The article highlighted the view held by some economists that an ongoing capital goods boom would cushion the economy from any material diminishment that might come from higher interest rates. Just over a year later, in February 1980, the recession started. GDP declined by 2.2%, the unemployment rate jumped to 7.8%, and the S&P 500 suffered another 25% real decline.
In January of 1980, one month before that February 1980 recession began, the News-Journal was still touting the prospects of a “soft landing.” These soft landing calls underestimated not only the 1980 recession but also the infamous follow-up “double dip” recession of 1981 that trailed the 1980 downturn almost immediately. In the double-dip, GDP dropped another 2.8%, the unemployment rate hit a historic 10.8%, and the S&P 500 lost another 32% in real terms.
In Q4 of 1979, just ahead of these back-to-back recessions, the Conference Board’s coincident real-time economic indicator was expanding at a 0.6% rate. At the very same time, however, the leading LEI index had plunged to -9.4%. This massive divergence between the real-time coincident data and the LEI leading economic data accurately portrayed the coming change in economic conditions, as it had previously.
In late 1989, a communiqué from the Federal Reserve Bank of Cleveland asked the question that was on everyone’s mind after a series of Federal Reserve rate increases: “How Soft a Landing?” Analysts were pretty sure growth was going to cool gently and without a painful downturn. The question was, how gently?
One prominent paper pronounced, “U.S. Economy Seems Headed For A Soft Landing.” A New York Times headline declared “A ‘Soft Landing’ Is Forecast.” The Times article reported that “Top business economists predicted today that the United States economy is headed for a ‘soft landing’ this year in which growth slows enough to tame inflation and interest rates without toppling the country into a recession.”
In November of 1989, the Washington Post confidently cheered, “A Soft Landing for Economy Is Now at Hand.” In the article, the Post, which ensured that history often rhymes, opened with “The American economy, which many forecasters expected would have crashed in flames by now, appears to be coming in for a soft landing.” In 1990, the economy descended into a recession in which the unemployment rate would shoot to 7.8% and the S&P 500 would lose 20% in real terms.
Before recession hit, however, there were warnings. In the quarter before the start of the recession, while the Conference Board’s coincident real-time economic index was at a comfortable soft landing-supportive +2%, the leading LEI index wasn’t buying the soft-landing hype. The LEI non-confirmed the growth story with a negative 2% reading. Once again, the real-time coincident index told you where you were; the leading LEI index spoke of where things were headed.
Speeding our time-traveling DeLorean to the year 2000, the American Banker issued the headline “Soft Landing in Sight For Economy: Rate Cut Next?” The article noted increasing signs that the Fed would pull off an immaculate dismount from the tightening cycle in which it was engaged, without an economic contraction.
Another notable headline just ahead of the start of recession came from the New York Times. In a Market Insight column titled, “Making A Soft Landing Even Softer,” the Times interviewed then-Deutsche Bank Chief Investment Strategist Ed Yardeni. Yardeni was (and still is) a fervent believer in the soft-landing scenario. He issued his soft-landing forecast at the time because, as he said of Fed Chair Greenspan, everything “he was hoping for is happening,” and, “the imbalances that were [in the economy] earlier have been corrected.”
In July of the year 2000, it was Bloomberg that issued the always-irresistible soft landing siren call with the headline, “Cleared For A Soft Landing.” The article, which featured the subtitle, “the economy seems to be responding to Greenspan’s tuning,” declared that “The Fed Chairman should sit back and smile: The U.S. is currently enjoying an almost idyllic economy.”
That “almost idyllic economy” in the summer of 2000 sounds an awful lot like the summer of 2023’s “goldilocks” economy. The earlier rendition was “almost” idyllic indeed. At the time, the S&P 500 was in a bear market rally that brought the index to within 1.5% of the cycle peak before rolling over and dropping 50% (the Nasdaq was far, far worse). The “almost idyllic economy” slipped into recession, and the unemployment rate jumped from 3.8% to 6.3%.
As before, market participants could have avoided a colossal mauling by focusing on the combination of bubble valuations and leading economic data. In Q4 of 2000, the quarter ahead of the recession’s start, the Conference Board’s coincident real-time economic index offered life to the soft-landing narrative with a positive 0.6% reading. At the same time, however, another of these highly anomalous divergences, common only at major cycle turning points, flashed a warning signal. As the real-time data remained positive, the leading LEI index was down 7.6%. Once again, the LEI presaged the direction of both markets and the economy.
Next stop on our time travel extravaganza is the 2007-2009 great recession. Surely this eventual doozy of a downturn could never have been confused ahead of time with a soft landing! Oh, but it certainly was. A 2007 press release from the Dow Jones Indexes/STOXX Ltd. Global Economic Outlook Conference offered the headline, “Analysts: 2007 Soft Landing Should Boost U.S. Markets.” Not only did this collection of top economists and renowned Wall Street analysts predict a soft-landing, some went so far as to suggest the economy was already through the soft-landing by the first half of 2007—before the eventual rock-hard recession hit in December of 2007. The Chief Economist for IHS Global Insight, a major global economic forecasting organization, was quoted as saying, “The soft landing of the U.S. and global economies seems to be over and the balance of risks seems to have shifted towards stronger growth.” Remarkable!
In 2007, even then-Fed chairman Bernanke was touting the soft-landing narrative. In February, an International Herald Tribune headline read, “Fed Chairman projects ‘soft landing’ for U.S. economy.” The article suggested that the soft-landing outlook “essentially portrays a ‘Goldilocks’ economy that is neither too hot with inflation nor too cold with rising unemployment.” Wow, that sounds eerily familiar!
Nevertheless, despite the aggressive soft-landing narrative in 2007—a narrative that persisted until the second half of 2008, the Great Recession wasn’t a soft landing by any stretch, rather a landing without landing gear. It was as hard a crash as modern economies and markets have known outside of the Great Depression. Unemployment spiked to 10%, GDP plunged by 5.1%, and the S&P 500 lost over 57% of its market value.
As in previous instances, the costly soft-landing fake-out of investors could have been avoided. By Q4 2007, the same quarter the recession started, a pronounced divergence had developed between coincident real-time economic data and the leading data. While the Conference Board’s coincident real-time index was growing at a 0.6% annualized pace, the leading LEI index had collapsed to -8%. Again, leading data leads. While the timing is often variable and unpredictable, historically the outcome is not.
Returning to the DeLorean and heading back to our present Q3 2023 moment, we see some strikingly familiar sights. We see a Fed monetary policy tightening cycle potentially at or nearing its peak, we see a slowing late-cycle U.S. and global economy, and we see serious concerns over a nasty pending recession suddenly drowned out by vocal proclamations of a soft-landing all-clear. According to the Wall Street Journal, we have “A Soft Landing in Sight for the U.S. Economy.” For CNBC, “The Pathway to a Soft Landing is Still Very Much Possible.” Bloomberg sees, “Labor Data to Fuel Soft-Landing Narrative.” Reuters recently observed that, “Wall Street Ends Week Higher on U.S. Soft Landing Hopes.” Over at the Financial Times, it’s already time to celebrate as “Confidence Grows That Federal Reserve Can Deliver a Soft Landing for U.S Economy.”
Perhaps this time the headlines are right. The once feared recession hasn’t yet materialized, coincident real-time growth remains positive, the stock market has recovered most of last year’s losses, and the soft-landing narrative has surged to an apparent consensus view among market participants. In this context, stock market momentum-driven FOMO-turned-POMO is tough to manage responsibly. Perhaps the stock market is, after all, on a non-stop express route to lavish market riches.
Despite the abundant enthusiasm of our modern moment, however, if we heed the unambiguously clear primary lesson of our time-travel tour de force, we can keep our heads, maintain focus, manage risk with our eyes on the ball, and make good decisions in a tricky environment. As always in markets, any and all potentialities are possible (even when they aren’t probable), and a soft landing along with surging asset prices could certainly happen.
Portfolios must be positioned for that possibility accordingly, but a hefty dose of caution is warranted when gauging current probabilities. As has happened in every recession during the Conference Board’s over 60-year history, a major divergence between the real-time coincident growth index and the leading LEI index is non-confirming the soft-landing optimism (again, this is a divergence that historically happens only at major economic cycle turning points). This time, the non-confirmation is violent.
While the latest coincident real-time economic index is running at a positive 0.8% annualized rate, the historically perfect 13-variable leading LEI index isn’t buying the soft-landing narrative at all. After 15 months of an accelerating decline—the longest streak of consecutive decreases since the run-up to the Great Recession, the leading LEI index screams, “warning—hard recessionary landing ahead!” The LEI is mired in an accelerating downtrend, now crashing at a -9.3% annualized rate. As a result, the official Conference Board forecast is for recession—one they believe could start as soon as the current third quarter.
To underscore the point, despite the National Bureau of Economic Research (NBER) dating the Great Recession’s start as December 2007, Wall Street consensus had the odds of recession at only 50% in 2008’s third quarter—nine months into contraction and an already live recession. At present, despite the soft-landing hysteria and confident stock market, the LEI has fallen straight through the trap door and into the basement, and negative revisions continue to roll in. Still, current Street consensus is that recession probability is 60%.
In addition, keep in mind that in November of last year, before the massive sentiment shift in the direction of the soft-landing narrative, the highly historically accurate New York Fed 12-month recession model pegged recession odds at just over 70%. Despite the market sentiment swing since, the NY Fed model is unfazed. It currently sits at 97%. Should the recession manifest, all asset prices will be impacted in varying but significant ways, and the stock market—currently at near all-time high valuations—is not prepared.
Again, a recession could be avoided. It is possible. But if that happens, it almost certainly won’t be for healthy reasons. The huge government deficit spending that Piper Sandler now projects could annualize at $1.9 trillion (with other estimates as high as $2.1 trillion) could potentially keep growth resilient if the spending is sustained or increased. If that happens, however, such deficit spending would further the debt & deficit doom-loop, as well as the likelihood of the devastating inflationary fire scenario discussed last week.
Again, what seems most probable is recessionary ice. Given our current government fiscal trajectory, the inflationary fire scenario certainly becomes increasingly likely over time. However, for this market cycle HAI still favors the icy option. The possibility of a stable perpetual goldilocks scenario complete with a renewed and sustainable bull market in financial assets, given current dynamics, lags far behind as a very distant third-place prospect.
As Dr. Benjamin Anderson reminds us, “Every era of speculation brings forth a crop of theories designed to justify the speculation, and the speculative slogans are easily seized upon. The term ‘new era’ was the slogan for the 1927–1929 period. We were in a new era in which old economic laws were suspended.” In our modern moment, the first priority should be to construct a portfolio that protects wealth against recession risk from the “old economic laws” that have, with perfect historical precision, unfailingly applied themselves with predictable, consistent, and painful results.
That said, it might be different this time. We may be in a “new era,” and some economic laws and previously dependable relationships may be suspended. It’s certainly possible that we’ve already reached that point. If it is different this time, however, rather than looking for the difference in new era “slogans” such as “interest rate insensitive,” “bullet proof consumer,” “unbreakable labor market,” or “transformative AI revolution,” HAI would instead look to a potential “new era” involving the inflationary, potentially crack-up boom-like impact of a game-changing government debt & deficit doom-loop. To hedge that outcome, it doesn’t take a trip back in time to conclude that precious metals, favored hard-asset commodities, and their related producers are the time-tested best bet.
Weekly performance: The S&P 500 dropped 0.31%. Gold was off 1.49%, silver lost 4.13%, platinum was down 1.50%, and palladium was up 3.52%. The HUI gold miners index was off 0.20%. The IFRA iShares US Infrastructure ETF was nearly flat, up 0.10%. Energy commodities were volatile and higher on the week. WTI crude oil was up by 0.45% while natural gas gained 7.49%. The CRB Commodity Index was nearly flat, up 0.10%, while copper was down 3.88%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.86%, and the Vanguard Utilities ETF was up 0.84%. The dollar index gained 0.83% to close the week at 102.69. The yield on the 10-yr Treasury was up 11 bps, ending the week at 4.16%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
