Recession Is Coming, and It Could Be Lengthy

Barron’s spoke with Sløk on May 10 about the stock market impact of a weakening economy, why a housing recovery might be premature, and the potential risks to the global economy of looming changes in Japan.

An edited version of the conversation follows.

Barron’s: What is the outlook for the U.S. economy now that we have seen more regional bank failures?

Torsten Sløk: The consensus estimates a soft landing, expecting we will have a recession in the third and fourth quarters, with a 0.5% decline in gross domestic product in the third quarter and a 0.5% decline in the fourth. That translates into negative 200,000 in nonfarm payrolls for every month from July to December.

The banking crisis has created a higher risk of a deeper or longer recession. We are leaning toward a hard landing because of much tighter credit conditions and the fear that rates will stay more elevated because the Fed will be worried about inflation being stickier.

Even the consensus estimate implies a lot of job losses. Will it solve the inflation problem?

During the Covid pandemic, immigration declined. But over the past two and a half years, immigration has increased by four million—the same number the Brookings Institution estimates left the labor market because of long Covid.

To put the [inflation] genie back in the bottle involves getting wage inflation to move lower. The labor supply has increased, in particular for prime-age workers, and immigration has increased, which is helpful. But more work has to be done for inflation to fall to a more sustainable level.

Where else do you see inflationary pressures?

Data on the number of prospective new-home buyers, and home-builder and home-buyer confidence, are starting to move higher. Existing—and new—home sales are moving higher. And the average number of offers received for a sold property is going up. Six months ago, it was about two bids on average; now it is more than three. Housing accounts for 40% of the consumer price index. If housing begins to recover, the Fed will be stuck in a difficult situation of stickier inflation.

How does stickier inflation relate to the banks’ recent troubles?

JPMorgan Chase
[ticker: JPM] and
Bank of America
[BAC], combined, make up 26% of all assets in the U.S. banking sector. The 13biggest banks together comprise 60% of assets. The other 40% are facing higher funding costs, which might be the case well into next year. Over the past several months, banks have been looking at their deposits with very different eyes.

Are they worried about a run on deposits similar to that which brought down Silicon Valley Bank?

In 2013, 39% of people used mobile and online banking. Now it’s 66%, and using an iPhone to bank makes it much easier to shift your deposits elsewhere. There is the risk that bank deposits could disappear quickly.

Banks also face other headwinds. The value of their Treasury and mortgage holdings has declined by so much that many banks are sitting on significant declines in their safe and risk-free assets, and there is probably more regulatory scrutiny coming to regional banks.

I started my career at the IMF. The first thing you learn is that banking crises normally happen in a bad economy because the banks start losing money on loans to consumers, corporates, and commercial real estate. What is so unusual today is that with the collapse of the 14th-largest and 16th-largest banks [
First Republic Bank
and Silicon Valley Bank, respectively], we have what I would describe as a banking crisis in a good economy—and we are about to enter a bad economy.

What are the implications as the economy weakens?

Asset prices are already down in banks’ most liquid [holdings]. If there is a recession, there is risk to the illiquid part due to credit losses related to consumers and corporate business.

Small banks—Nos. 26 to 4,500 in size—make up roughly 37% of all lending in the banking sector. Banks’ willingness to lend to consumers isn’t quite down at 2008 levels, but the trend is not our friend.

If the sources of financing from high-yield markets, primary issuances, and regional banks have essentially dried up, private credit and private capital have been stepping in and acting as a stabilizer by lending.

Have private markets felt a strain yet from the rapid increase in interest rates and a slowing economy?

As interest rates rose, technology and growth companies suffered because long-duration cash flows are highly sensitive to the federal-funds rate. In private markets, it’s exactly the same. Many tech companies and companies with levered bets on low interest rates are now suffering. The total value of venture capital is down 60% since the Fed started raising rates, according to Refinitiv. The crunch in tech—in the Nasdaq, venture capital, and growth stocks—will continue because the cost of capital is likely to stay high.

When do you expect interest rates to head lower?

[Inflation] went from 9% last June to 5% today. Getting inflation from 5% to 2% is going to be a lot harder.

The market expects the Fed to cut rates in September. It will probably take until the middle of next year before it can cut rates because inflation is so sticky and the Fed’s mandate from Congress is to get inflation down to 2%.

Things that are interest-sensitive are likely to remain negatively impacted. That means the housing recovery is probably premature. The Fed will simply not allow the housing market to recover if that involves inflation moving higher. We are likely to have stagflation for the next three quarters—elevated inflation and a contraction in GDP.

What types of investments are most at risk?

Lower-rated credits, in particular bonds rated triple-C and high-yield [securities], will be hurt by the double whammy of high rates, which means a higher cost of financing, and low growth, which means lower earnings and lower profitability.

Should you buy the S&P 500 today? No, because you can probably buy it cheaper in three or six months. The [positive] outlook for 12-month forward earnings per share for the S&P 500 is stunning,given the drop in expectations for real growth and consensus expectations for a recession.

But in 12 to 24 months’ time, these things will blow over. Long-term investors should do their homework and look at the things that are beaten up.

Commercial real estate is losing value. What is the economic impact?

Within real estate investment trusts, offices haven’t been doing well but industrial and warehouse REITs still have positive returns. This isn’t like 2008, when the problem was uniform and residential real estate made up 7% of GDP.

Commercial real estate today accounts for only about 2.5% of GDP. In 2008, GDP declined 3%. GDP will decline over the next three quarters by roughly half a percentage point. This recession is going to be much milder than in 2008, although it could be longer.

How will we know when the worst is over?

Once the vacancy rates of commercial properties and the price per square foot begin to turn around, that will be a bullish sign for stock market investors and the economy. The problem is that the vacancy rate is still going up, and the price per square foot of office space is down 30% from the peak.

What else should investors monitor?

TSA [Transportation Security Administration] data on how many people are flying on airplanes; how many are going to movie theaters and Broadway shows and staying at hotels. When consumers have burned through their savings and don’t have money to do all these things, that will be the business-cycle inflection point we’re waiting for.

Restaurant performance has shown some signs of weakness. Jobless claims are gradually moving up. Tech workers are normally high-paid workers and may not apply for unemployment benefits, so they might not be included. Since that’s where we have seen most of the layoffs, the unemployment rate might truly be at a higher level. There are some early signs the services are seeing a slowdown. Investors shouldn’t underestimate the Fed’s commitment to get inflation back to 2%, and with that will come the risk of a sharper slowdown.

What are you monitoring beyond the U.S.?

It’s important to pay attention to statements from the
Bank of Japan
about yield-curve controls, which have kept Japanese interest rates near zero for seven years. Since 2016, the Bank of Japan said it was going to buy an unlimited amount of [Japanese government] bonds to make sure that 10-year rates didn’t go up.

With rates in their own backyard very low, Japanese insurers and banks invested in U.S. Treasuries, U.S. investment-grade bonds, and European bonds. If over the next six months Japan says it will now allow interest rates to rise, the risk is that Japanese investors will begin to repatriate money because yields on Japanese government bonds will be moving higher.

What are the ripple effects?

Japan is the biggest foreign holder of U.S. Treasuries, with more than $1 trillion. If Japanese investors begin to sell those Treasuries, U.S. Treasury rates could rise and U.S. credit spreads could widen. Even if Japanese investors do nothing, there’s the risk the rest of the world could say they want to offload their U.S. Treasury bonds and credit if Japan is about to do so. This is an event risk not appreciated in financial markets.

Could Japan’s move negate the need for further Fed tightening?

Yes. But there is the risk of a substantial and uncontrolled move [in rates] that poses all kinds of risks to the global economy.

Thanks, Torsten.

Write to Reshma Kapadia at [email protected]