David Rosenberg honestly doesn’t want to be bearish on stocks or bash the Federal Reserve. The veteran market strategist will get no satisfaction if he’s right about Americans having to slog through recession and consequently endure deflation, job losses and a wallop to the stock market.
“As I play the role of economic detective, I can see the smoking gun,” says Rosenberg, a former chief North American economist at Merrill Lynch and now president of Toronto-based Rosenberg Research.
Who’s holding the weapon? Central bankers, Rosenberg says, adding: “We are feeling the pinch from everything the Fed has done over the past 12 months.”
Rosenberg is known for providing investors with straight assessments of the financial markets. His timing can be early, but often Rosenberg finds the consensus migrates to his corner. That’s happening now with his conviction that a recession in U.S. corporate earnings will bring higher unemployment, lower stock prices, and force the Fed to cut interest rates “hard and fast” in an effort to calm both the economy and the financial markets.
In this recent interview, which has been edited for clarity, Rosenberg doubled-down on the bearish case he made almost three months ago in a MarketWatch interview. That worrisome picture is now even more troubling after the failure of Silicon Valley Bank in March and heightened fears on Wall Street and Main Street about what happens when a U.S. economy thirsty for credit and loans finds those spigots are running dry.
MarketWatch: When we last spoke in early February, you saw no end to the bear market. Are we there yet?
Rosenberg: There’s no “get out of jail free card” when the most important banker in the world — the Federal Reserve — raises rates aggressively into the most inverted yield curve since the spring of 1981. The question all along was where the excess and imbalance and resource misallocation would be exposed.
Fed tightening cycles always result in some sort of accident. They don’t always have to be a financial accident. But normally we see financial stresses come to the fore at the late stages of a Fed rate-hiking program. So if anything, both my macro- and market view have been emboldened by what’s happened to the regional banks.
There’s always more than one cockroach in the kitchen. We’re in the early chapters of a looming credit contraction. It’s not necessarily going to be a financial crisis; the big banks are in reasonably good shape when it comes to capitalization and liquidity.
“ The elephant in the room is commercial real estate.”
MarketWatch: So Silicon Valley Bank’s failure and the broader banking crisis may not in fact tank the economy. But clearly you’re worried.
SVB’s failure is a reminder of the fragilities that exist in U.S. regional banks, which are called small banks but are not really that small. They have been deregulated. They’ve never been compelled to pass stress tests. They became a valve for credit expansion when the large banks were put into the penalty box by regulators and supervisors.
The elephant in the room now is commercial real estate, which is a huge, leveraged sector and represents the lion’s share of assets on regional bank balance sheets. That is the big problem going forward.
Commercial real estate is oversupplied. Vacancy rates are in the double-digits in most urban areas. Values are deflating rapidly and defaults are starting to mount. This is the next leg in the story. This is not about residential mortgages; that was the last cycle.
Staring us in the face is a tightening in financial conditions as the banks now will be forced more than they have been at any other point in this cycle towards focusing on their balance sheet, capital position, and that is going to come at the expense of credit creation for an economy that is driven by credit.
MarketWatch: Tighter reins on credit and borrowing won’t be limited to commercial real estate. Households and businesses will feel the pinch of illiquidity. How might those adverse conditions play out in the economy and for investors?
Rosenberg: This is going to exacerbate the recessionary pressures already coming to the fore. We’re seeing early signs of it: total banking sector deposits in the four weeks to March 29 collapsed at a 30% annual rate. Outstanding credit in the private sector has shrunk at a 3.5% annual rate. That is a very rare occurrence. The declines are spread across commercial and industrial loans, non-residential real estate, mortgages and auto loans.
The punishingly high cost of credit is bumping against a restriction in the availability of credit, and therein lies the recession outcome. We’re on the receiving end of NFIB small business sentiment survey. Small companies have more difficulty accessing credit than at any other time in the past 10 years. This is still early chapters of the book otherwise known as credit contraction.
As far as households are concerned, the New York Fed released its March survey of consumer behavior and it hasn’t yet shown up in the macro data. Where is the recession? I think it’s starting this quarter.
In the meantime we have a Fed that refuses to take a side on the 3.5% unemployment rate or the 6% inflation rate. That poses another problem because recessions don’t end until the Fed eases policy substantially to the point where the yield curve moves from inversion to a more positive slope.
So the best we can hope for is recovery sometime next year, given how long the policy lags are. We are feeling the pinch from everything the Fed has done over the past 12 months, which is the most pernicious tightening cycle since 1981. For anybody that needs a history lesson, 1981 was followed in 1982 by no walk in the park for the economy, for equities or for corporate credit.
MarketWatch: Why keep any money in a regional bank now? Shouldn’t people be wary about the risk?
Rosenberg: The government has said it will backstop deposits for any banks that fail. But what if my bank fails? Who wants the headache of having to go apply and then wait for your deposits to be replenished? The reality is we continue to see deposit outflows and the money is flowing into money market funds backed by Treasury bills.
Part of the dilemma is the banks never really raised their savings deposit rates to a level competitive with what you get in the Treasury bill market. Only now are people starting to wake up to this yield gap. The problem for the banks is they’re going to have to raise their deposit rates to stem the outflow or try to find other ways to raise capital, which right now would be very expensive.
“ Banks are going to be pulling in their horns when it comes to credit extension. That’s going to make for a murky outlook for an economy that runs on credit. ”
As far as the big banks are concerned, this is more of a cloud over earnings and loan-loss provisioning and margin compression from having to raise deposit rates. We probably come out of this cycle with the big banks even bigger and maybe even stronger.
For stock investors, if you have a 12-month outlook, better opportunities in the financials probably lie ahead. We’re going to be seeing more negative earnings guidance and loan-loss provisioning that will weigh heavily on the earnings outlook for this sector.
We could end up with a domino effect. The history of bank failures is that they start off with a prevailing view of the crisis being contained and the authorities moving forcefully to backstop the situation. But we know that there is a risk of more cockroaches in the kitchen.
Even if that doesn’t happen, the one certainty is that the banks are going to be pulling in their horns when it comes to credit extension. That’s going to make for a murky outlook for an economy that runs on credit.
Businesses are telling you that the access to loans is the toughest in a decade. Households are telling you the same. This new chapter of the Fed tightening book has just started. It’s deflationary. The Fed is waiting for all of this to show up in the data. By then it’s going to be too late.
“ By June or July, we will start to see headline employment numbers roll over. At that point the Fed will be cutting rates. ”
But this central bank continues to believe that its credibility was tarnished by inflation ramping up to over 9% at the peak. So the Fed has been and will remain deliberately slow and eventually will cut rates aggressively, but only when the coincident and contemporaneous indicators they are focusing on begin to roll over.
Principally, what they’re really waiting for is for a contraction in non-farm payrolls. For them, that is the holy grail. I don’t think it will be a long wait.
We’re starting to see cracks in the labor market. We are seeing contraction in important, economically sensitive sectors: financials; retailers; manufacturing, and construction. Companies are cutting hours worked. The work week is a leading economic indicator. Non-farm payrolls are a coincident indicator. The unemployment rate is a lagging indicator. The work week is a classic leading barometer because employers tend to cut hours before they cut staff.
As I play the role of economic detective, I can see the smoking gun. By June or July, we will start to see headline employment numbers roll over. At that point the Fed will be cutting rates.
The Fed is telling us that their forecast is 4.5% unemployment. We’re at 3.5%. That could be the equivalent of 1.5 to 2 million jobs lost. That is what happens in a recession. Remember that these forecasts were before this banking sector crisis. You never fail to have a recession with unemployment up a full percentage point, but the Fed is telling you that’s what they want to see.
On top of that, the Fed is calling for practically no growth at all this year. The Fed is also telling us they expect a negative GDP print in the second-, third- and fourth quarters. They’ve told us that their forecast is for a mild recession.
“ ‘There is no soft landing. The only question now is will the recession be mild or severe.’ ”
MarketWatch: Many investors and strategists have learned this past year not to fight the Fed, but are convinced the central bank will nail a “soft-landing” for the U.S. economy. What do you expect?
Rosenberg: There is no soft landing. The only question now is will the recession be mild or severe. A lot of that will depend on the duration and the extent in the contraction in credit that lies around the bend. The Fed implicitly is calling for a recession. A soft landing that follows the Fed tightening cycle has happened 20% of the time. But at those times the Fed was not tightening into an inverted yield curve.
The futures market is pricing in two rate cuts in the second half of the year. I think the Fed will be cutting rates a lot more. When I say this, people look at me as though I’m from outer space. But what is so controversial about that call? Everything moves in cycles. We know that in recessions, whether severe or mild, the Fed historically cuts the funds rate by 500 basis points. They’re not going to signal that right now, with unemployment at 3.5% and inflation at 6%, but that is the historical record.
“ Interest rates are going to be coming down hard and fast. Inflation is going to melt. ”
At a minimum, they’re going to have to take the funds rate down to 2.5%. They’re going to have to cut rates a lot, because the one thing that hasn’t changed in this cycle is the Fed’s own view of where the neutral fed funds rate is, and that is 2.5%.
Getting to 2.5% is only eliminating the excess tightening that they’ve put into the system in the past year. A lot of people don’t realize the extent of the tightening in monetary policy. The current funds rate is double the Fed’s own estimate of neutral. Which is why the yield curve is inverted as it’s been, and the money supply is contracting at an unprecedented 2.5% annual rate.
MarketWatch: Put simply, what is the key takeaway here for investors as they watch the Fed and consider their next money moves?
Rosenberg: We are at peak expansion, peak credit, peak inflation and peak interest rates. The operative word is “peak,” and now we’re going to roll over. Interest rates are going to be coming down hard and fast. Inflation is going to melt. I realize that is a controversial view because everybody is fighting yesterday’s story, which is headline inflation and low unemployment — and those are lagging indicators.
The most important data are going to be the bank lending numbers, the forward guidance from the banks, loan-loss provisioning, the survey data indicating the extent to which credit is being choked off to the household and business sectors. These are what we should focus on.
It all leads to a deflationary, not inflationary, environment. People out there talking about shortages of labor, materials, de-globalization, secular inflation — let’s wait and see over the next five- to 10 years how all these play out.
MarketWatch: Stocks have defied these economic headwinds — perhaps unrealistically. Does the rally concern you?
Rosenberg: For the U.S. stock market as a whole, it’s incredible and egregious that the S&P 500 would be up in the context of what is going to be a five-quarter-long earnings recession.
“ We have a hugely overvalued stock market. The multiple today is higher than it was at the credit market bubble peak in 2007. ”
You can debate the GDP recession, but investors pay for earnings, and earnings are contracting and estimates are coming down. So we have a hugely overvalued stock market. The multiple today is higher than it was at the credit market bubble peak in 2007. It’s above the average peak for the price-earnings multiple that defined the highs of previous bull market cycles. There is going to be a day of reckoning.
I’m very concerned over where the level of credit spreads are, because they are not priced for a recession. Investors have a soft landing embedded in their mentality and positioning. That has me concerned because that is not my macro view.
MarketWatch: How should investors respond and position their portfolios now?
Rosenberg: In terms of where you put your money, if you have my recession view, you want to have cash insofar as the Fed continues to pay you to be in cash. You want to be long Treasurys, which always rally in a recession.
In the stock market, I would be in areas that have low correlation with the economic cycle, strong balance sheets, high earnings visibility and low earnings volatility, and in companies that don’t have much in the way of debt maturing in the coming year. I would be very defensive — exposure to consumer staples, utilities, health care. There may be some defensive growth within technology that will benefit from lower long-term interest rates. But be mindful of excessive valuation.
I also like gold. The U.S. dollar
will come under downward pressure. Gold will be a great hedge against the declining greenback. I’ve been advocating the bond-bullion barbell. I like the safety and the ballast in a portfolio that government bonds offer in troubled economic times which lie ahead and not fully priced in.
“ If we get a 2.5% 10-year Treasury yield and the S&P 500 down towards the 3,000 level, that will be a call to start dipping into the risk pool. ”
MarketWatch: How will investors know that this bear market has finally bottomed?
Rosenberg: What I know about economic and financial history is that fundamental bear market lows occur only after the Fed has cut interest rates significantly, re-steepened the yield curve, and with the bond market helping re-establish a more appropriate equity risk premium.
We are in an ongoing earnings recession. The stock market is going to need the bond market’s help. Traditionally, the stock market bottoms only after bond yields have come down substantially. So if you’re bullish on stocks you have to first be bullish on bonds. We have to get to an equity-risk premium that is more than double where we are today, which means in excess of 400 basis points.
That is the alarm bell. If we get a 2.5% 10-year Treasury yield and the S&P 500 down towards the 3,000 level, that will be a call to start dipping into the risk pool. Who knows? I might become David Rosenberg, permabull, and I am looking forward to that day.