10 things that are 'different this time'
Standard models and frameworks are less useful in rocky landings.
The rapid collapse of Silicon Valley Bank (SVB) could be a harbinger of worse to come for the broader banking sector, though we doubt it. SVB was uniquely exposed to the very area of the capital markets that enjoyed one of the greatest valuation bubbles since the late 1990s: technology start-ups. The bubble in these 40x prospective revenue names without earnings already burst hard last year following the Fed’s policy shift to dramatic rate hikes. For some of us, it just seemed a matter of time before the backwash from this collapse in its depositor base would come back to hit the bank. Virtually no other banks in the system have this unique exposure, and the biggest ones, importantly, remain highly diversified with fortress balance sheets that are unlikely to be significantly affected by the goings on here. However, we do think as a minimum the meltdown at SVB will suggest to the Fed that it might be best to give the system a little more time before taking rates too much higher. In our view, the most likely outcome now is just a couple more 25 basis-point hikes, then a long pause. And possibly an acceptance by the Fed that for now, as much as it would like to get inflation back to 2% soon, that’s going to be tough and trying too hard to do so might only make matters worse, not better. This all fits with our prolonged “Rocky Landing” scenario.
As we talk through our ongoing “Rocky Landing” outlook with clients, investors, economists and Wall Street strategists, reactions seem unusually wide-ranging and diverse. And today’s news of a still strong labor market though perhaps softening wage pressures, alongside the sudden downfall of the Silicon Valley Bank, is just adding to the murkiness of everyone’s “crystal ball.”
Some hope for a “soft” or even “no landing,” a world in which the economy rolls onward and upward uninterrupted, inflation falls back on its own weight and the Fed goes back to a low-rate regime. As much as we'd all celebrate this idea, we see no more than a 5% probability of this Goldilocks outcome. Then there is the more predominant consensus recession call, “that sooner or later, the Fed will cause a recession, or maybe even a crisis.” Although we acknowledge that a recession, which we would define as a broad-based, synchronous decline in the economy, jobs and corporate earnings, is possible, we are assigning it something like a 30% probability. And by the way, yes of course we don’t like to see a big bank like Silicon Valley go under, but we don’t see it as the beginning of a systemic banking crisis that could plunge the U.S. economy into a broader downturn (see accompanying sidebar).
This leaves the remaining 60% probability on our ongoing base case, a rocky landing, which believe already is underway. Readers of this space by now know what a rocky landing is, so let me just summarize: a rocky landing is an asynchronous decline across sectors and countries, along with asynchronous inflation pressures within different elements of the workforce and across different product and service categories. Similar to, but not exactly a “rolling recession,’’ which implies that various sectors decline somewhat sequentially. To the opposite, this asynchrony results in economic data being volatile and mixed, causing GDP to bounce in aggregate around either side of zero until the world stabilizes within its new post Covid environment, with growth resuming albeit at likely a slower pace.
This memo explores some of the misconceptions and false assumptions that lie behind the broad recession call that we don’t share. That consensus is based largely on historical analogs, frameworks and statistics that presume to be applicable going forward, and normally are. But we are in anything but a normal world, so here are 10 reasons things could be different this time:
- The yield curve could be inverted because the Fed is panicking over having started too late and/or investors are overly confident that long-term inflation will remain anchored at 2%. One of the primary mantras of the recession bears is that an inverted yield curve is “100% accurate” in forecasting recessions. This assumption normally “works” because the Fed’s high rates “break something” and that “something” then breaks the economy, forcing the Fed to about-face and cut rates to re-liquify the system. Playing this out, long-term rates at these temporarily high levels would prove to be a good long-term opportunity. That all may yet prove to be the case, but we don’t think the breaking of a bank almost entirely focused on the sliver of the economy that was most in a bubble (tech start-ups) is it. And what if the economy doesn’t buckle quite so quickly (see points 2, 3, 4, 5)? Then, the Fed’s predicted rate cut might not come quite so fast, and long bond buyers at current long-term yields might not have made such a good move foregoing higher short-term rates on the short side of the curve. And what if the short rates, on the other hand, are also a tad too high (see point 5 below)? Maybe the extra rate hikes being predicted won't be necessary, bringing short rates down and flattening the curve away from the recession call. We think both these forces may be at work.
- Inflation driven partly by supply-side problems may be much harder to fix. There’s no doubt the more than $9 trillion of fiscal and monetary stimulus doled out to combat the steep (but short) Covid recession fed an unprecedented spending spree, fueling inflationary forces as people chased too few goods in a variety of sectors. But even as the excess savings and spending are wearing down, some of the other supply-side impacts of the pandemic remain with us. Baby boomers retired permanently, and two-earner couples shifted to one-earner couples to better manage their even now partial-stay-at-home families. Younger workers decided they simply didn’t want to work in many of the service industries where they previously often got their start. Manufacturers are struggling to find, and keep, skilled workers too. In general, this labor shortage seems likely to be with us for a while and given the still disproportionate gap between job openings and unemployment, wage pressures may be hard to cure entirely with the usual methods. And the longer jobs and wages hold up, evidenced again in today’s jobs report, the longer the consumer is going to hold up.
- The trend toward reshoring, which runs counter to the primary deflationary driver of the last 30 years, might also be making the Fed’s job tougher. If Covid lockdowns in China, the war in Ukraine and geopolitical tensions between the U.S. and both countries have taught corporate America anything, it’s that it must diversify its supply chain. “Reshoring” and “friend-shoring” were heard frequently in fourth quarter earnings calls, with companies searching for friendlier and closer sources for materials, components and production. Adding fuel to this reshoring shift, new fiscal initiatives supporting the construction of chip-making and renewable energy facilities in the U.S. All of this is keeping domestic economic activity “stronger for longer” even as the Fed is attempting to quell it.
- The U.S. economy’s secular shift toward services and asset-light businesses might have made it less sensitive to interest-rate hikes in general. Digital platforms and software are replacing asset-heavy inventories and people across many industries. Think Uber or Airbnb, whose business models don’t rely on corporate ownership of assets. Because services and asset-light business models rely less on heavy debt financing, interest rate hikes may be less effective than they’ve been historically in slowing the economy.
- At the same time, the market dynamics of the last five years might have created a new disinflationary effect of rate hikes that could be a very powerful inflation curative. One reason wage increases got out of hand over the last three years has to be the extraordinarily cheap capital being handed to young entrepreneurs for building tech businesses that could generate revenues but maybe not earnings. Let’s face it, when investors are handing you capital at 40x prospective revenues, you’ll pay any price you can to hire workers that can help generate revenues! These drunken sailors in the room certainly have been disruptive to the broader labor market, so now that these stocks have been toasted by the Fed’s aggressive rate hikes, the drunken sailors have been dragged by their heels out of the room. It’s possible that the well-publicized layoffs we’re seeing in this sector, though relatively small in the grand scheme of the U.S. economy, might be having an outsized sobering effect on labor markets and therefore on inflation, without the big unemployment gains the Fed thinks it needs. We’ll see. But today’s report of wage pressures easing somewhat even as payroll increases surprise to the upside would be consistent with this possibility. And this along with the breakdown at Silicon Valley Bank might very well give the Fed good reason to slow down its rate hikes, or maybe even to rethink the practicality of trying to get inflation back to 2% instead of, maybe, 3% (see sidebar).
- Global geopolitics might be eradicating the great post-Cold War peace dividend of the last 30 years, again making the Fed’s job tougher. This in many ways reflects what was discussed in point 3, above. As relations turn increasingly sour between the U.S. and Western democracies and their adversaries in Russia, China and parts of the Middle East and Central America, regional trading blocs are replacing what was perhaps a fleeting era of global cooperation that allowed companies to shop the world. Just this week, Russia launched a number of hypersonic missiles at Ukraine, perhaps for the first time. Actions like this are going to lead both Western and Asian military powers (think U.S. and China) to spend yet more money on similar weapons. More spending. More stimulus.
- Post-Covid imbalances in savings, investment and consumption patterns might be making a lot of models and “seasonal adjustments” temporarily haywire. While seasonal adjustments are determined over years, the Covid- and post-Covid era caused unprecedented shifts in behavior. It pulled forward huge investments in hard goods such as furniture and at-home entertainment such as streaming. Some $5+ trillion of stimulus checks and relief pumped up household savings, with an estimated $1.2 trillion of so-called excess savings still floating around. Meanwhile, a wave of baby boomer retirements, a boom in work from home and the acceleration of online retailing and online work are creating havoc with labor-force measures (the sample response for JOLTS data, for example, has fallen by half since 2019) and historical work and shopping patterns.
- Investor presumptions about growth stocks following their decade-long run might be very wrong. The Covid boom gave way to massive overinvestment by Big Tech companies that seemed to think their virtual world was replacing the real world. There was no way the spending trends early in the pandemic, on new technology and online services, would continue forever—there’s only so many computers and new TVs and shows a family can stream. Similarly, once a home is refurbished and refreshed, it’s done. More broadly, growth stocks enjoyed a decade of ultra-low interest rates, an environment that seems unlikely to return in this era of scarcity and supply constraints. Tech multiples, already hit by the rise in the discount rate, could take another hit if investors begin to rethink what their long-term growth rates are.
- Everything might not be shaped like a “V.” We’ve written before about this bias built into market expectations following 15 years of booms and busts that began with the 2007 real estate crash. But in the current environment, with a well-capitalized banking system and broadly healthy consumer and corporate balance sheets, it could be that the various economic sectors are adjusting one at a time, such that the overall effect and Fed response is less sharply shaped; more like a series of small “Ws” than a “V.” We’ll see.
- The bond market, and the Fed for that matter, might be absolutely clueless. I cringe when I hear investors and television pundits note that “the bond market is always right!” Really? A year ago, the all-knowing Fed had short rates pegged at 25 basis points, and bond market seers had 10-year Treasury yields under 2.0%. Uh, a little off….
Given all the uncertainties and countervailing pressures noted above, it’s quite possible that the months ahead will feature little data point victories for bulls and bears alike as one economic sector after another, but not together, lurch and bounce along the runway. This week’s news featured a jobs report with data for both sides of the bull/bear debate, alongside a classic bank run—albeit of a bank uniquely exposed to some of the biggest bubble stocks from the bull cycle which ended over a year ago now. As investors overreact to each big rock we hit, or miss, ahead, markets are likely to move up, down, and up again—we think within our broadly defined range of 3,600 to 4,400 on the S&P 500. The good news is that with each passing month, the plane will be that much closer to a smooth taxiing pace. Along the way, we’ll keep clipping our dividends. And should we get that retest of the summer lows soon, which seems likely, look to this space. We’ll probably be buying.