Albert Edwards: Expect a bad recession

Albert Edwards at Societe Generale brings the meaning as usual.

The US recession seems imminent and the market discussion has shifted to its magnitude. Forecasts of a “mild” recession will now abound. But when a key Fed economic model sees an 80% chance of a hard landing, you know things are bad!

The media now calls me a “market veteran”. This is the code of the fact that I have been hitting the markets for a very long time – 40 years. One of the benefits of being a market veteran is that my long-term memory improves with age (or at least I believe it does) in reverse to the deterioration in my short-term memory. So once again, as the recession and market crash looms, familiar phrases return to greet me like long-lost friends. But their return doesn’t bring much comfort. Instead, they are ringing the alarm bells.

Indeed, it was only recently that we heard the Fed’s well-known end-of-cycle dismissal of the inversion of the 2a-10a part of the yield curve as a recession predictor.

And I’ve read with increasing regularity that stocks have fallen so rapidly, well ahead of earnings, that “stocks have already priced in a recession”. Another alarm bell has just rung!

There really is no more pretense now that the Fed has, in an act of penance for allowing inflation to spiral out of control, donned a horsehair shirt and is fully prepared to plunge the economy America in recession. Powell speaking of a “soft landing” was as explicit an admission of recessionary intent as I remember from a Fed Chairman.

Market commentators are now determinedly asserting that the recession (which they never anticipated in the first place) will be shallow. This is again a normal false benchmark that we cross at this point in the cycle before all hell breaks loose and the economy and markets crash.

Perhaps the most interesting question is not how deep the recession will be, but how deep will yields fall? The recent surge in inflation has broken the tight link between real economy data and bond yields (see chart below). Will a recession (temporarily) dispel inflation fears and lead to a substantial drop in bond yields? The outlook for commodities is key, especially in the context of the war in Ukraine. But I still see commodity prices plunging like in the fourth quarter of 2008, pushing headline CPI inflation from +5% to -2% in just 12 months. Could we see 10-year returns below 1% again? Now, that would be quite a surprise.

Global Strategy WeeklyJune 22, 2022Signs of a US recession are growing almost daily. It’s not just that the “here and now” for the Atlanta Fed’s Q2GDP is zero (after -1.5% in Q1). Leading indicators also look gloomy. For example, the Conference Board leading indicator fell for the third consecutive month in May and it is now 4 declines in the last 5 months. This is normally the case with a recession, and indeed the 3-month percent change has recently fallen the most since the last recession (red line in the chart below), although to be fair, the percent change 6-month change (which, according to the Conference Board itself, is the best predictor of recession) is still not quite below its 2016 low (dotted line in the chart below).

But even taking the slightly less bearish 6 million% change in the leading indicator, the ISM manufacturing should now collapse by about 10 percentage points very quickly.

This pace of decline in the ISM, one of the most publicized economic data points, certainly lines up with a recent forecast from one of the New York Fed’s own economic recession models.

While a ½% drop in GDP doesn’t sound particularly hard-hitting, it’s quite shocking to see that in just 3 months, the New York Fed model has cut its GDP forecast for this year by 1½% and the next ! Moreover, the duration of the forecast recession – two full years – is extraordinary. Add to that probably the most bearish comment I’ve ever heard from a Fed Bank – “chances of a hard landing are about 80%” and wow! Some of the great work I like to read every week is @Callum_Thomas’ Weekly Chart Storm (available on Substack and Twitter). This week, he notes [email protected]head of market strategy at Nordea, pointed out that “the problem with the lower (current) P/E ratios is that while the P has moved, the E is on a thin layer of ice – and the cracks are starting to show. ..” – see graph below.

Assume – plausibly – for a moment that the US economy suffers a hard landing and the S&P crash resumes quickly. Needless to say, then, at some point, rising unemployment and market chaos will force the Fed to capitulate, or as it euphemistically calls it, pause its tightening cycle! And then the next step, as the economy collapses, will be to cut rates to zero and resume QE. We’ve been on this trip before and we know what’s going on.

The counter-argument to this is that the Fed will stay the course of tightening due to soaring inflation. And they can do it for a short time, but what if headline inflation crashes?

Commodity prices are already clearly reversing (see left chart below) with oil and agricultural commodity prices slower to decline. This is probably partly due to the war in Ukraine, but we saw a similar slower cyclical response in oil and agricultural commodity prices in the second half of 2008 (right chart). Meanwhile, the UBS industrial metals index is around 30% off its March high and copper is down 20% (see chart). If (when) the oil and agriculture complex joins this bear market, headline CPI inflation could quickly collapse below zero, just as it did in 2008/9, when headline CPI is from +5% to -2% in just 12 months. A similar drop to negative inflation would likely cause bond yields to fall substantially, even if core CPI remains stable above 2%. While a sub-1% 10-year return seems entirely plausible to me, I suspect we won’t see a further drop below the 0.3% March 2020 low as the secular Ice Age trend lower lows and higher highs with each cycle is broken. The new secular trend may now be higher inflation and higher yields, but a cyclical recessionary shock lies ahead.

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