Is Wall Street Missing A Recession Spurred on by Corporate Debt? (w/ David Rosenberg)
ED HARRISON: David Rosenberg, it's a pleasure to talk to you. I've heard a lot about you. I've watched you over the course of, say, 15 or 20 years. And it's a great opportunity to get to pick your brain here about investment opportunities. DAVID ROSENBERG: Well, you know they say. There's lean pickings, so good luck to you. ED HARRISON: Well, you know, in terms of the pickings, I'm thinking in this sort of 6- to 18- month time frame, sort of a medium-term look. And so what I wanted to get a sense is, is what are you looking at in terms of where should Americans have their investment asset allocation over the medium term, over that, say, the rest of this year through to the end of 2020? DAVID ROSENBERG: Right. Well, I think that we have seen for this cycle the peak in growth, and the peak in inflation, and the peak in interest rates. I think the Fed has already pretty well told us that. So I think that what you want to have in your portfolio is a barbell between what works in a very slow-growth environment, perhaps, I would hazard to say, even a recession environment, where you want to be exposed to long-term bonds. High-quality, long-duration bonds should be a core holding in your portfolio. And I think within the equity market to really be focused on what works well and a declining interest rate backdrop, which are dividend-paying stocks, so whether they be the financials, they be the utilities-- I'm bullish on REITs. But within the stock market, you want to have a bent towards what works well when interest rates go down. Do you want to be defensive? So you don't want to be cyclical. But you want to take advantage of the lower interest rates, which means dividend growth, dividend yield with companies that have low payout ratios. If you have to be in the equity market, that's where you want to be. ED HARRISON: Right. I want to get at that from two different angles. One is is the angle what you were talking about in terms of the rates, but also there's the real economy side because you do a lot of stuff in a real economy side. So let's actually start with the real economy side. I'm thinking in terms of the American consumer and jobs. When you look at that, where are you looking first in terms of where the chinks in the armor are and why we're actually slowing down? DAVID ROSENBERG: Sure. Well, I'll tell you that no two cycles are the same. No two bubbles are the same. And no two recessions are the same. So this isn't 10, 12 years ago when I would have been focused on, what? I'd be focused on housing. I'd be focused on the consumer. This time around, it's not about the consumer. It's really about capital spending. It's about the business sector. Because the bubble, this time, it was not where it was in the last time. Lightning doesn't strike twice. We have a gigantic bubble on corporate balance sheets. And this is going to be a year-- this is the first year of five years where more than a trillion dollars of corporate bonds are going to be rolling over and rolling over at interest rates that were higher than they were at the time of origination. And we have another situation where half of the investment-grade market right now, which is $3 trillion worth, is in triple-B credit. So these are called potential fallen angels where you potentially could get pushed into junk-bond status, which is a pretty big deal if that were to happen. What I'm sensing is that most companies are going to do everything they possibly can to not get pushed out of triple-B status into junk bonds where their debt cost to capital is going to skyrocket. So what does that mean? It means that in this environment where profit growth is decelerating, cash flows are decelerating, and those cash flows will be challenged and will face a lot of competition from wages and also from rising debt service costs, so companies are going to have a choice in the coming year. You know, where do stock buybacks play a role here? I think those are going to dissipate a lot. But capital spending is going to be the key. I think capital spending this year is going to be the precipitating factor for the recession. It's not going to be about consumers. It's not going to be about housing. There's no bubbles there. But I think that to forestall the possibility of being downgraded to junk bonds, you're going to find a lot of companies paring back on their capital spending plans. And actually, I think that it's a pretty easy call. Every single survey I'm paying attention to right now was showing that capital spending attentions are rolling over and rolling over significantly. And if you're going to ask me, what particular indicator am I looking at this cycle to confirm or, say, not to confirm my forecast, the one high frequency indicator is core capex orders. That comes out of the monthly durables. Nobody seems to talk about this. It's down for the past five months, down at a 5% annual rate. And so, to me, that's going to lead to a capital spending recession. It's not going to be a deep recession. There'll be knock-on effects on employment. Employment will be the last thing to go down. There'll be a knock-on lagged impact on the consumer. But it's going to be something sort of like what happened in 2001, 2002. I mean, this isn't a tech-wreck sort of a situation. But that was a capital spending recession, a mild one. It had knock-on impacts on the rest of the economy, was a mild recession. But it was a mild recession nonetheless. And people think, well, it's a mild recession. I shouldn't be so worried about the stock market as an asset class. But there's no correlation between the severity of a recession and the severity of the market reaction. If you go back to that period, mildest recession of all time, actually, 2001, 2002, GDP barely declined. And yet, the NASDAQ was down 80%, peak to trough. And what people will then say, well, but that was off technology. OK, but the S&P 500, that cycle was down 40%. So I think that this will be a capital spending-led recession. We're seeing the early stages of that already. I know it's not showing up on a lot of the consumer indicators or the employment indicators. That will come later. But capital spending right now is being severely challenged. ED HARRISON: Well, when you start talking about capital spending, the first thing that comes to mind for me is, what's going to happen to commercial real estate? I'm not talking necessarily about multifamily home. I'm thinking about actual office space, and companies like WeWork, and so forth. So when you talk about REITs, why do you think that REITs are actually going to do well in that sort of environment? DAVID ROSENBERG: Well, you know, REITs are not exactly a homogeneous area to invest in. There is real estate REITs, but there's also health care REITs. And there's other forms you can play, cash flows and other parts of the real estate market. There's not a bubble in multifamily. There's not a bubble in housing, generally speaking. Commercial real estate, you could argue, is a place, where if there was a lot more leverage to the cycle, an area I might be avoiding. But there's other REITs that you can actually play. And health care REITs, by the way, would be one that would be, I think, a potential winner in an otherwise bleak stock market outlook in the next, say, four to six quarters. ED HARRISON: When you talked about buybacks, I thought that was very interesting. Because when you think about a leveraged-up company where 50% of the companies that are corporate debt are triple-B, that would suggest that there's no more releveraging of the balance sheet. They can't get any juice out of that. So what does that say in terms of where EPS growth is going for, say, the S&P? DAVID ROSENBERG: Well, it's a great question. I think that's going to be really a double whammy on earnings. The first or just the gross dollar level, I think it's going to be going down because the economy is going to be weakening. And domestically, that's going to be the lagged impact of everything the Fed has done but, also, the lagged impact of what's happening in the global economy, the strong dollar. That's going to hit the dollar level of earnings. But of course, we always look at earnings per share. And that was a defining feature of the cycle, right? How did this happen? We had the weakest economic expansion of all time and one of the most wonderful bull markets. How do you square that circle? It's because when you're watching the business television shows, and they show company x, y, or z, they're not showing the dollar billions or hundreds of billions of earnings. They're doing earnings per share. It's always per share. Well, the stock buyback craze was so intense that the share count at the S&P 500, the cycle's gone down to a two-decade low. So I think what's going to be changing, and not just the dollar level of earnings in a recessionary environment, but the divisor is going to be challenged as well. I think we're going to go into a much different equity buyback situation. I think buybacks will be put on the back burner for the first time in a long time because companies are going to have a choice. Do we continue with buybacks? Do we actually go on a capital spending project? Or do we service our debt and retire our debt? And really, that's the principal theme for the coming year. In the last cycle, it was belt tightening and deleveraging in the household sector. Back in 2001, 2002, it was belt tightening and deleveraging in the corporate sector. We're back to that. It is going to be a classic deleveraging focus on debt retirement, debt service, which isn't the end of the world. But it's going to come at the expense of buybacks, which is going to come back and then bite the equity market in the behind. And it's going to come at the expense of GDP. Now, capital spending is not the consumer. Consumer is 70% of GDP. That's why a consumer recession like we had in the last cycle could have a very pernicious, negative impact on the economy. Corporate spending is 10% of GDP. So it's going to be a mild recession. But as I said before, there's no "get out of jail free" card with any sort of recession as far as what it means for the overall markets. ED HARRISON: Right. So actually, I wanted to talk about the Fed. But actually, off camera we were talking about some other stuff just before. And one of the things that I have a question about is these triple-Bs. When these triple-Bs-- and you know, actually, a lot of these triple-Bs are actually trading like they're junk already. I'm talking about near-junk type of credits that are trading like they're double-B-plus or double-Bs. What happens when they actually do fall into the junk-bond status? DAVID ROSENBERG: Right. Well, OK, firstly, this is a case where size does matter. Because 10 years ago, 30% of the investment-grade credit market was triple-B. Today it's over 50%. We've never seen this before. And $3 trillion, I mean, that's double the size of what subprime was a decade ago. If we're talking about a situation where there's a big bulge of, say, double-A credits that are at risk of getting downgraded to single-A, that's not that big of a deal. You're still in the investmentgrade universe. The difference is that when you get pushed out of triple-Bs, which is one tranche away from junk, and you get pushed into a junk, and that's what's referred to as a fallen angel. Well, all of a sudden, entities with quality mandates, like insurance companies and pension funds, can't own your paper anymore. So there's a fire sale. And what happens is that your debt cost of capital skyrockets, at least to a general widening and spreads. It leads to a tightening in financial conditions. And there's knock-on effects to other markets as well. And that, in and of itself, the tightening of financial conditions, will generate a recession. And this is what we were talking about is that we're at a crossroads right now. It's almost pick your poison. We either go through a cycle of fallen angels, companies get pushed into junk-bond status-- that will lead to a different sort of recession, and probably a more pernicious one than the one I'm describing, which is that companies actually put debt servicing, servicing their debts, at the top priority, protecting the bondholders as their priority. It's not the end of the world. It will trigger though a decline in capital spending that will lead to a mild recession. ED HARRISON: So you're an optimist, you're saying. DAVID ROSENBERG: Well, it's a relative gain. ED HARRISON: Right. DAVID ROSENBERG: But I'm saying, at this stage, those are your two basic outcomes. I'm actually talking about what companies will do in a rational sense. And I think that they will do everything they can to stave off a default or stave off a downgrade. And so in answer to your question that you were posing before is, what is the quality of the debt that's out there right now? And your point is well taken, that it's interesting to me that over 30% of the companies in this triple-B universe actually have their debt-to-EBITDA ratios in line with the average in the junk-bond market. ED HARRISON: Right. DAVID ROSENBERG: But yet the rating agencies only have 5% of this triple-B universe on credit watch with negative implications. So the knee-jerk reaction is, oh, well, you know, there's Fitch, and S&P, and Moody's, once again, backstopping the issuer at the expense of the investor. But no, no, no-- that's not what is happening. What's happening is that these companies have gone to the rating agencies and shown them their capital-spending plans for the coming year. And it convinced them that they are going to stay current in terms of their debt-servicing schedule. But I think that we're talking about something a lot more domestic and homegrown here, which is the credit cycle and what that means for the domestic economy and, of course, what it means coming off a fairly aggressive Fed tightening cycle. ED HARRISON: Right. You mentioned the word "aggressive," a fairly aggressive rate tightening cycle, so going to 0 to 2.5% in the course of a very short period of time. And the Fed not only increased the number of rate hikes that they were going to do last year, but they were also rolling off their balance sheet. So my question is, where does the Fed go from here? DAVID ROSENBERG: OK, well, when you actually look at what's called a shadow Fed funds rate and you look at it on a balance sheet adjusted basis, so the nine hikes plus what they've already done on balance sheet downsizing, the net effect has been the equivalent of 340 basis points of Fed tightening. And historically, that has been enough to tip the balance towards a recession. It's at least as much as what the Fed did back in 1990, '91. It's pretty well in line with what the Fed did back into the 2001 recession. So this is a fairly, I would say, a fairly aggressive Fed tightening cycle, especially when you consider that there really wasn't much in the way of inflation. Where does the Fed go from here? Well, I think that Jay Powell, he pushed the envelope. I mean, he raised rates as far as he possibly could. ED HARRISON: And people were screaming for him to raise rates anyway, right? I mean, people were saying that the Fed is not-- you know, they're behind the curve. DAVID ROSENBERG: Well, until they weren't. What's interesting about Jay Powell is that it was almost like he was suffering some case of cognitive dissonance. Because he comes in, and he's talking about r-star, the neutral funds rate, and he's poking fun at these economists that talk about r-star. And he's talking about constellations and that this is more like astronomy. And that-- all he talked about was the neutral funds rate. That's all he talked about. He comes in. We've got to normalize rates. And actually it was October the 3rd when he said in that interview, which he probably regrets, about not just having to go to neutral, whatever that is, but we have to go above neutral. And that's when the Trump tweets started coming out with a high degree of frequency. So the proof of the pudding is in the eating. Look at what happened December 19-- December 19, in the middle of a huge correction in the stock market. I mean, stock market's down 20%. Cyclical stocks, together, were down 30%. The regional banks were down 30%. The small caps were down 30%. Oil was down 40%. And we've never seen the Fed, even under Paul Volcker, raise interest rates in that sort of environment. And it was interesting to me because the Fed talked so much about tightening December 19, at one point the market was priced 100% of the way. But going into the meeting on December 19, the market was priced 70%. So the money market gave the Fed a window to not have to do anything-- maybe say, we'll take a pass. Well, look what happened. They raised rates into a maelstrom-- OK, unprecedented. Pledges that were not done, we have two more under our belt, and then talks about the balance sheet being on autopilot in the press conference-- oops. And so, basically, I don't even know if it was so much about the markets pushing the Fed, or I don't think it was about the president pushing the Fed. I think a lot of business contacts spent a lot of time telling the Fed what was happening in the economy. And then, of course, it was a little while later, we got the Fed Beige Book, the last Fed Beige Book, which was one of the weakest that I've seen for the cycle. So I think a lot of it came down to the economy. ED HARRISON: So do you think he made a mistake? DAVID ROSENBERG: I do. I do. I think that historians will be writing about it. That's not the first time the Fed has over-tightened. And the concept of the neutral funds rate or the utopian world of full employment, and price stability, and the natural rate of interest in that environment is a missing-- it's a moving target, right? It was like 5, 6 years ago, the Fed was telling you that their estimate of neutral was 4. Can you imagine they went to 4? ED HARRISON: Right. DAVID ROSENBERG: And then what happened is that before Jay Powell became chairman, they had taken that number all the way down to 2 and 3/4. And what does Powell do at the first number of meetings-- takes it up to 3. Now it went down to 2 and 3/4. Now, I'm pretty sure, because he used the word "appropriate" to describe where the funds rate level is appropriate three times in the last press conference, so 2 and 1/2 now, I think, is the considered to be neutral, 2 and 1/2. I think that they're going to find out-- ED HARRISON: They're done, basically. DAVID ROSENBERG: Oh, they're done. But I think that neutral-- when I do my own work on where neutral is, it's not even at 2%. So I think they over-tightened like three times. And you think what would happen. Look, segments of the yield curve inverted. We had the cyclical stock down 30%. We had the bear market in commodities. And right at that time when Jay Powell was screaming "uncle" himself and pivoting, real M1 growth had gone negative for the first time since before the last recession. So there were lots of indicators there of strains. And maybe the most important one, which is more qualitative than quantitative, which I think caught his eye, finally-- because, remember, he's got a credit background-- was the fact that we went at least a month, maybe two months, without there being a corporate bond issue, like the credit markets really froze up, and high yield spreads widened dramatically. So I think that was another telltale sign. But from my perspective, it's too late. From my perspective, we can talk about what the Fed's going to be doing. The Fed will be cutting rates. It's in the second half of the year. I think they'll be cutting. I think they will. ED HARRISON: Oh, yeah. DAVID ROSENBERG: Because the Feds, historically, they move incrementally. They've already done a very big shift in terms of tone. So right now they're talking the talk. And then the second half of the year, they'll be walking the walk. And I think they'll be cutting rates. In fact, if you go to the July 31, August 1, FOMC minutes, you're going to find something very unusual, which is at the beginning of those minutes, the Fed staff, the economic staff, did a special presentation to the FOMC on the zero bound and how to fight the next recession. So they've handed to you on a silver platter, rates are going to zero. They tell, rates are going back to zero. In fact, they say, we will be spending several years retesting zero in the Fed funds rate-- sort of sounds like Japan, right? ED HARRISON: Right. DAVID ROSENBERG: So we're going to go back, so retesting zero. But right now, we're not at zero. We're at 2 and 1/2%. Rates are going to zero. They're going to re-expand the balance sheet, OK? And what they'll add to the balance sheet-- maybe, at this point, the Democrats have a sweep in 2020. I mean, we'll see. Maybe the Fed will be actually buying these infrastructure bonds as part of the modern monetary theory, which I think is a little crazy. But then again, people would have thought quantitative easing was a little crazy 12 years ago, and now it's part of the investment lexicon. Who doesn't know about QE? Rates are going to zero, more QE, and they might have to do QE-plus. So that's in our future the next two years. That's why I'm very bullish on interest rates. That's why-- you were asking before about dividend stocks do well in lower-rate environments, in declining-rate environments. But in the next two years, I have a strong conviction that the funds rate is going back down to zero. The Fed will be scrambling to ease policy conditions, which means that long-term rates will be going down as well. I think we're going to go back and retest those lows, the 2016 lows and the 10-year note at 135. I think we're going to go retest it. It's just unknown to me right now whether we'll actually break through it. At the same time, have a exposure to 30-year strips, zero-coupon bonds. Because if I'm right in my forecast, in the next two years, without taking any equity risk, they will probably generate a return between 30% and 40%. Under the proviso that I'm right where bond yields are going. But if the Fed's telling you, this is a gift that they're going back down to zero on the Fed funds rate. The whole curve is going down. So there's a lot of money to be made in the bond market, even at these low interest-rate levels and not because of the coupon, because of the capital gain you're going to get as rates drop. ED HARRISON: Well, we're going to leave it there. That is-- I think it's a great scenario for an investor, a great opportunity. It's not, necessarily, for the economy. But it's been a pleasure to talk to you about it. DAVID ROSENBERG: Well, thanks for inviting me in. ED HARRISON: Thank you.