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.

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