The Dividend Cafe - Recession Watch: The Perfect Call

Episode Date: January 27, 2023

The month of January has launched 2023 in a very different direction than 2022 thus far. I do not mean because markets are up thus far whereas they were down in 2022 (though technically both of those things are true). But beyond the mere directional change in markets (which could reverse at the drop of a hat), the themes and factors influencing markets – in other words, the stuff that matters – has changed. Moving way down the totem pole has been what the Fed is doing or is expected to do, and moving way up in priority (to the very top) is what will happen in the economy as a result of what the Fed has already done. I am going to elaborate on what that means in today’s Dividend Cafe, and more importantly, make the case for and against a 2023 recession. And I hope that after reading my case you will decide I have made the perfect call … Let’s jump in to the Dividend Cafe. Links mentioned in this episode: TheDCToday.com [DividendCafe.com] https://bahnsen.co/3WIokXu TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to the Dividend Cafe. And forgive me for the casual attire, but I am jumping on an airplane here. It has been a absolutely phenomenal week in New York City. here. It has been an absolutely phenomenal week in New York City. I assure you, very long suit and tie days, but nevertheless, very productive, some wonderful meetings. And now I'm really looking forward to getting back to California with my family and back in the Newport Beach office all of next week. Today's Dividend Cafe is going to explore this issue about recession. I've written Dividend Cafe is about recession before. One of the things I've had and I wrote one that was well trafficked last year about the dreaded R word.

me, although it's not really where we're going with today, which is the unpredictability of how to apply a portfolio or market call to recessionary dynamics. In other words, if someone did know, and I'm about to make the case that no one most certainly does, if someone did know what exactly was about to take place with the economy, I do not believe that there are portfolio managers, and I most certainly do not believe there are regular investors that could take that data and perfectly apply it, that the challenge would still be there

as to knowing what has been priced in and knowing certain timing issues, knowing the depths and severities that could be at stake and all of that type of stuff. And just in terms of market response in general, there's a confounding element to markets that applies to currency, to fixed income, to the rate markets, to commodities, to equity prices, to valuations, to real estate. So knowing what the macro circumstances are, which is impossible, and applying them to portfolio are two different things. But what I want to talk about is the setup of the market right now, the setup of the kind of sentiment realities, Now, the setup of the kind of sentiment realities and point out that this first month of 2023,

again, we still, as I'm recording, have two or three, about two and a half market days left in the month. But so far, it's been a positive month and pretty darn good one. There's been a lot of ups and downs, but no, it's been a solid month for risk assets. But, you know, who knows where things go? But my point is not so much that what markets have done this month to talk about contrasting 2023 so far to 2022. It's not about a market outcome. It is true that after 26 days, markets are up and last year markets were down. That's actually not my point, though. My point is that the conversation is not right now about what really was driving market pricing last year. Last year, the obsession was, what's the Fed going to do? How tight are they going to go? Are they going to go tighter? When are they going to stop? And then, of course, that led to a big evaluation

in terms of the inputs that would affect Fed decision making. But right now, I believe it's almost universally accepted within a certain bandwidth where the Fed is. Now, it is true. Someone could disagree, you know, if a quarter point of the next meeting and then a half a point after that, or a quarter point at the next meeting and then done, a quarter point at the next meeting and a quarter point at the meeting after that seems to be futures pricing expectation right now. So that's the most baked in. So you're at 425 right now in the Fed funds rate. And there's outcomes between 450 and five as a terminal. The most prevalent is about 475. Who cares? I mean, the point is people see the Fed stopping in months

and there is a group that still says, oh no, they're gonna go to six, seven, they keep on going. That's fine, but that's a pretty fringe view. It's not within the consensus. It's not within pricing. It's not within, you know, various outcomes in the rate market, the yield curve, Fed funds futures. really, really wrong. But the focus is, regardless of the specifics, the Fed's about to pause. And therefore, now I get to start Dividend Cafe today. If we're not talking about the specifics of what's going to happen with interest rates in the Fed, then what we're talking about is the outcome from what the Fed has done. In other words, will there be a recession? Will there be a soft landing? How hard of a recession will there be? And so forth. And the notion

of a economic slowdown perhaps not being as severe as people feared is becoming a growing expectation. I was on stage yesterday at an event in New York with Jason Trenner, who's the CEO of Strategas Research and a macroeconomist I know and think highly of. And he said he put 50 percent odds on a pretty normal recession, 40% on a soft landing and 10% on no recession at all. So that's 50-50 essentially between the kind of better camp and the worst camp. So I don't want to put odds on it. I just want to show you right now fundamentally why I believe there are pretty darn compelling arguments for a recession coming and pretty

compelling arguments for why one may not come or there's a sort of mitigation against a recession. The first and foremost argument, by the way, is not causative. It's not because this has happened, it's going to create a recession. It is predictive. And that is the yield curve. And we've been talking about forever. The two-year and 10-year have been inverted now for, let's see, I believe we're looking at over six months and rather substantially inverted. Right now we're sitting in between 65 and 70 basis points. Let's call it roughly 420 on the two year and roughly 350 on the 10 year.

We've been there for a little bit and that curve has stayed 65 to 70 sloped, even if an inverted slope, even if the total rates went from 450 and 380 respectively down, right? So the spread between the two has stayed at that 65 to 70 basis point level. That's significant. That's been a long time of it. And there was a yield curve inversion in 2006 before the 08 recession. There was a yield curve inversion in 2000 before the 02 recession. But there have been rarely, but nevertheless, there have been yield curves that inverted that did not lead to recession. And there have been yield curves that didn't invert and there ended up being recession, what we would call both a false positive factor and a false negative factor. So this one, I think, is screaming that there's a policy error at the Fed and that there's an expectation for a recession coming.

I point out, again, it is predictive, not causative. And yet, other aspects in the Fed market could become causative. But they're not there, which would be blowing out credit spreads, widening credit spreads that then because of that illiquidity, capital removed from the system, widening spread that means higher borrowing costs for some aspect of leveraged finance and the corporate sector and real estate or what have you. And those things can become recessionary, but they just simply haven't happened yet. Now, number two, I think, is the Purchasing Managers Index, the PMIs that we refer to either in manufacturing or in services.

And they both now for some time have been pointing to declining business activity. And the manufacturing side was there longer. The services side is catching up to the downside. And that negative push in the PMIs is often fundamentally foreshadowed a recession. The third is industrial production. And again, I talk about PMIs and IP, the industrial production, because I think it is far more significant than consumer and retail activity for reasons I've talked about a lot. You don't need to worry about Americans' appetite to shop. They love spending money. You have to worry about their capacity to do so, meaning access to credit and income. of the matter is that industrial production, which is an index looking at more production-oriented and less consumption-oriented activities from manufacturing to mining to utilities,

that it had a significant drop in December. And it had been trending up post-COVID and reversed. It hasn't been a long drop, and there's a chart of this at dividendcafe.com. I think it's significant. And so I would encourage you to look at those three things, yield curve, ISM and industrial production as pretty compelling cases for a recession to come. But then the other side of this and you go, OK, hold on, what are you doing here? Harry Truman's one armed economist because he's tired of hearing on one hand and on the other hand. I do this as intellectual honesty. I do this because objective presentation of data is the burden of a financially serious person. You do not ignore data because it goes against the narrative of other data. And I will tell you

that the employment data remains a real challenge for those that are headstrong, sure of a recession coming. I totally understand it could change, but a three and a half percent unemployment rate, a 10 and a half million unfilled job level. Another way of saying it is 10.5 million job openings and wages that have increased, not decreased. Weekly initial jobless claims that have come down over the last several months. They're not only not at a high level, they're a lower level as the Fed's been tightening. They're not only not at a high level, they're a lower level as the Fed's been tightening. They're even in the face of a lot of announced high profile technology layoffs.

The labor data doesn't support a recession thesis yet. It can change, obviously. But right now that has to be taken into account. One data point that you say, OK, maybe there's a crack in the armor here is hours worked. Average hourly average hours worked have come down a tiny bit in the last two months. That could be foreshadowing to more layoffs coming. It hasn't moved much and it's been more recent, but that's something we'll keep an eye on. Number two, though, I think is the household debt levels. We were at 115% of household debt to disposable income as a ratio going in the financial crisis recession. It's down about 90% now. I'd

rather it be at 60 or 70. I still think it's too high for a macroeconomic read, but it's a lot lower. 25% reduction from 115 to 90. It gives more buffer to the ability of households to withstand certain recessionary or contractionary conditions. The third is that housing has often been associated with recessionary activities, both the recession in 1990 and obviously the great financial crisis of 2008. And a lot of people relying on extracting equity from their homes, and that dried up. And a lot of people that then took a hit to their ability in the economy

because they had adjustable rate mortgages. And so as rates went higher, it impacted their monthly disposable income. However, we were at something like 35% of people in 2008 with adjustable rate mortgages. We're at 6% in the last couple of years. And so there's a much lower risk level of people that are already owners of homes, all of a sudden having effectively a pay cut as a home payment rises. Now, for new home buyers, rates are higher, and therefore they're going to buy at this level. They're going to have a bigger chunk of monthly income go to the payment.

But of course, that through time gets mitigated by lower prices, as I wrote about and talked about in my housing issue last week. But the adjustable rate reality, the household debt reality and the job dynamic are all compelling arguments, either for a very soft type situation or no recession at all. Corporate debt, by the way, is in this kind of none of the above category because on one hand, the amount of debt service as a percentage of operating income is still very low. And a lot of that is because companies did obtain very favorable rates. And so even though rates have gone up, they were already locked into

a better rate scenario. And the denominator operating income has gone up a lot. Now, look, operating income can start coming down if you get weakening economic conditions and the cost of debt service can go up. If some of those rates do start to reset. There is certainly a lot of floating rate out there. But for now, you still have a favorable debt ratio in the corporate sector. But there is high levels of corporate debt. Absolute dollar levels of debt are very high. So I just see that as sort of in kind of no man's land, a sort of purgatory input to our recession evaluation. So this is how I'm going to conclude with a conclusion, what I'm calling the perfect call. The perfect call is that nobody knows. And you say, come on, I listened to this for that. But let me elaborate.

It is very destructive for someone to tell you that there will be one in the face of the three counterpoints. And it's very destructive to say there will will be one in the face of the three counterpoints. And it's very destructive to say there will not be one in the face of the three arguments that I made earlier. And if one has all six facts on the table, they can then go to an inkling. And I have an inkling that there will be a recession. And I have anecdotal support that it will be a mild one. But there is no way I'm going to present that to people that I have a fiduciary duty to as actionable. The various compelling tug of war of economic data right now is real. And I have no agenda for there to be one or not be one. There's political

agendas that are out there. There are business model agendas. I've written before about these perma bear people. This is just simply not where you want to be getting advice from. I am all for people looking objectively at all the data and leaning heavier for one side over the other, as long as it's done with that type of intellectual honesty that I'm trying to present. But the perfect call here is that I don't know, and neither does anybody else, and that your portfolio should not care. It should not matter that if there is a financial objective one has in their life,

and there ends up being a recession or not being a recession, one's portfolio should not have something happen to it that disarms the financial objective, that undermines and threatens the financial goal. So a portfolio that is bulletproofed in terms of goal achievement from the way this plays out in recession as the way someone has to be. And a lot of people are not aligned that way.

We work tirelessly to do that. And that's what we're going to continue to do. And I believe that's the perfect call around the 2023 ambiguity of a recession. I'm going to leave it there. I would encourage you to look at the charts at DividendCafe.com. I'd encourage you to reach out with any questions you may have. And we look forward to coming back to you again next week with a really wonderful DC Today on Monday. Thank you for listening to, watching, and reading The Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC.

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