So, you’re telling me there’s a chance!

February 22, 2023

In the classic comedy, Dumb & Dumber, Lloyd demonstrates the epitome of optimistic thinking when his crush, Mary, gives him a hard truth. Forced to answer the uncomfortable question of whether the two of them could conceivably end up together, Mary admits the odds are “not good”. In fact, it is “like one in a million”, she says. To which Lloyd responds after a moment of deep reflection, “So…you’re telling me there’s a chance.”

The Federal Reserve and its cadre of economists are currently hoping the economy will make a soft landing in 2023. They would like a way out of the painful inflation of 2022 and into a comfy low-inflation, positive growth environment. The Fed believes increasing short-term lending rates are just what is needed. Current economic conditions are responding a little like Mary, however. Current data suggests the odds of a gentle economic transition in 2023 are definitely “not good”.

The Soft-Landing Narrative

Recent mainstream financial headlines have discussed the growing possibility that the Fed is engineering a soft landing for the economy. This soft landing involves slowing inflation, a relatively stable or rising stock market, and the avoidance of recession. Recent data (at least on the face of it) has lent credibility to this outlook with January payrolls and retail sales both exceeding expectations. In addition, there has been a marginal improvement in several sentiment surveys. Some businesses are experiencing short-term relief from lower input costs due to falling transportation and energy prices.

Since the Federal Reserve has raised the federal funds rate to its highest level in nearly 15 years, a weak economy should have already been in freefall. The fact that it continues to hum along shows just how resilient and healthy the US economy really is.

What Are the Odds?

The problem with statistics, however, is that they can be twisted to convey almost any perspective.

“There are lies, damned lies, and statistics.” Mark Twain

Statistics are inherently problematic because they contain an aura of epistemological certainty that they simply do not have. Statistics are not just the result of “math” – they are the consequence of subjective judgments overlayed with a (sometimes rather thin) mathematical veneer.

This is especially true in regard to well-publicized data from the government, such as the oft-referenced “payroll report”. How many jobs were created in January? The report said the US added more than 500k jobs in January. That sounds fantastic until you realize that the BLS (Bureau of Labor and Statistics) didn’t actually count all those jobs. Instead, the headline number is extrapolated from the results of a survey that accounts for a small sample size of the overall economy. The numbers are then overlayed with “seasonal adjustments” and other subjective factors to provide the headline number. These headline numbers, however, are often revised up or down significantly in later months as a result of future adjustments to the complex equation being utilized to generate the headline number. See the problem?

Furthermore, even if we grant some legitimacy to the headline number the stats under the hood are alarming. Full-time jobs have declined over the past year while part-time jobs continue to increase. Replacing full-time workers with part-time workers is a common pre-recession warning, and certainly not consistent with an economy that is as “strong as hell”.

Similarly, strong retail sales are far from a harbinger of future economic growth, as they are often at their best right up until the beginning of a recession.

“Not Good”

Despite the rather dubious “positive” economic news recently, the odds of a soft landing are quite a bit lower than the recent headlines would suggest. How low, you ask? Maybe it’s best not to put a number on it (at least not yet), but instead, provide a list of some of the most concerning economic data points.

Leading Indicators

  • The January SLOOS survey (Senior Loan Office Opinion Survey) indicates a significant contraction in bank credit over the past few quarters. Bank credit is largely responsible for inflating asset bubbles and creating the business cycle. If bank credit contracts, not only economic activity but asset bubbles generally decline. Importantly, bank credit typically begins shrinking before mainstream economists notice anything is wrong.
  • The S&P Global U.S. Composite PMI Index, which is another leading indicator of business activity, is currently in contraction and has been for several months.
  • The Conference Board’s Leading Economic Indicator (LEI) Index continues to point to a recession. Its current trajectory is only matched by the plunge during the Great Recession


Consumers Are Tapping Out

  • Personal real income continues to fall. For all the hoopla about the “tight” labor market and demand for labor, Americans’ cost of living continues to outpace their wage growth. This has been the case every month for nearly two years. Without an increase in real wages, consumer spending can’t keep up with rising prices and sooner rather than later industry will respond by contracting business activity.
  • That may be sooner rather than later, however, as the main source of consumer spending up until now was savings accumulated from pandemic stimulus payments. Lately, consumers have increasingly been relying on the use of credit cards to maintain their spending. However, credit card companies are now increasing interest rates and beginning to restrict additional credit. Meanwhile, many consumers are no doubt close to maxing out their credit lines.


Business Conditions Are Difficult

  • Excessive inventory overhangs for many retailers will continue to weigh on profits and should result in lower earnings going forward. If consumers should tap out their savings and credit cards, lower demand will lead companies to lower their prices. Liquidation of excess inventory at lower prices will lead to even lower earnings.
  •  In fact, demand may already be falling as indicated by the massive plunge in the Baltic Dry Index, a measure of global shipping costs. The index has fallen by 90% over the past 18 months and continues to make post-pandemic lows. It is currently plumbing the 2020 lows, below even where it was during the Great Recession in 2008.

Bond Markets Say Recession Is Coming

  • Perhaps the most striking indicator of a looming recession, however, is the myriad of global bond markets. The inverted yield curve in the US treasury bond market has been the most accurate forward-looking economic indicator for quite some time, occurring 12-18 months before every recession as far back as data is available. US Treasury bonds are currently at or near all-time inversion extremes. Below is a graph that charts the difference between the interest rates of the 10 Year Treasury and the 3 Month T-Bill. This “spread” should be positive if economic growth is expected in the near future. Currently, however, the level of inversion is greater than at any time in the past 50 years.
  • The US bond market is not alone. Around the world, we see unprecedented inversions in the German and British sovereign bond markets. There are inversions in the French and Italian bond markets as well. The Australian and Brazilian bond markets are experiencing inversions. Most significantly for the global economy, Eurodollar futures contracts (which are a proxy for a sort of international bond market) are experiencing massive inversions, providing yet another important financial market indicator pointing towards recession.

“Not Good’…like 1 In 100?”

All of these indicators point to storm clouds on the horizon. But the Fed seems undeterred in their pursuit of taming a supposedly hot economy. When the treasury yield curve began to flatten last year, this was brought to the Federal Reserve’s attention. At the time, Fed Chairman Jerome Powell suggested that this was nothing to be worried about. Instead, he argued, look to something the Fed calls the “Near Term Forward Spread” (NTFS). This phrase refers to the difference between the current 3-month T-bill rate and what the market expects the 3-month T-bill rate to be 18 months from now. This is the key indicator, the Chairman insisted.

“That’s really what has 100% of the explanatory power of the yield curve. It make sense. Because if it’s inverted, that means the Fed’s going to cut, which means the economy is weak.” Jerome Powell, March, 21st, 2022

At the time, that spread was over 2%. This gave Powell plenty of cover to suggest the economy was fine. Where is the NTFS today? Deep in the red at around -1%, exceeding all other inversions with the exception of the 1980-81 recession.


“More Like 1 In A Million”

At this point, it’s clear the data is saying the chances of a soft landing are slim to none. And yet many investors continue to behave like Lloyd and act as if there’s a real chance for a gentle 2023. I suppose if we dismiss the…

  • amazingly accurate forecasting of the global bond markets
  • the increasingly precarious situation of US consumers
  • the massive inventory overhang for US businesses
  • the tightening credit conditions and its effect on a heavily indebted economy
  • and the Federal Reserve’s own favored recession indicator currently flashing red

…then sure, you could say there’s a chance!

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