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Historically, the beginning of another credit tightening cycle means the beginning of another path to recession.
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Less than two years removed from a deep but brief Covid-induced recession in 2020, economists already have their eye on the next one. Gary Shilling thinks it could arrive by the end of 2022, providing a boost to bond prices and threatening stocks.
The Fed is preparing to raise interest rates three times this year, beginning the 13th cycle of credit tightening since World War II. Recessions have followed 11 of the previous 12–the only “soft landing,” when interest rates were raised and then reduced with no associated recession, came in 1994, so if history is any guide, it’s a matter of when a recession will hit, not if one is on the horizon.
Although quarterly GDP grew 6.9% in the fourth quarter year-over-year, excess inventories and slowing retail sales indicate that the contraction could come quickly in a worst-case scenario.
“We already see a softening of the economy in the first half of this year,” says Shilling, president of New Jersey consultancy A. Gary Shilling & Co and the former chief economist at Merrill Lynch. “When you put a Fed squeeze on top of that, that’s why I think you could have this recession starting before the end of this year.”
Inventory build-up accounted for 4.9 percentage points of the fourth-quarter GDP growth, with combined inventories at Target and Walmart hitting record highs by the end of the year. But with consumer sentiment at its lowest levels in more than a decade and retail sales down 1.9% in December, stores may need to slash orders to clear out their existing goods, lowering the economy’s growth potential.
That would be a bad omen for the S&P 500, which is down 5% this year despite a rebound in the last two weeks, but good news for bond prices, which have also declined this year with yields rising in anticipation of the Fed’s rate hikes.
Austin, Texas bond manager Hoisington Investment Management agrees with Shilling’s bearish economic view, but bullish view on bonds. “With money growth likely to slow even more sharply in response to tapering by the FOMC, the velocity of money in a major downward trend, coupled with increased global over-indebtedness, poor demographics and other headwinds at work, the faster observed inflation of last year should unwind noticeably in 2022,” says Hoisington’s quarterly review and outlook. Hoisington believes poor economic conditions overseas will draw foreign and domestic investors into long term U.S. Treasurys, thus pushing down yields.
Bonds have enjoyed a four-decade rally beginning in 1981, when the yield on the 30-year Treasury bond reached 14.6%. According to Bianco Research, $100 invested in a 25-year zero coupon bond when those yields peaked in October 1981 would be worth $39,600 now, an annual return of 16.2%. The same $100 invested in the S&P 500 at its bottom in 1982 would have grown to $11,600, a total return of 12.9% annually.
Bond prices have reversed course in the last 18 months, with 10-year Treasury yields nearing 2% for the first time since January 2020. Shilling thinks the market has already priced in this year’s expected rate hikes. Historically, each rise of 1 percentage point for the federal funds rate corresponds to a 0.36 percentage point increase in the 10-year yield, which is already up by 0.5% since the Fed signaled its intentions in December. With inflation also beginning to recede from month to month, yields might be peaking.
“In a recession, you’re going to get the Fed reversing gears. They oftentimes reverse gears even before the recession starts, recognizing that they’ve done the deed,” Shilling says. “You get a run for treasuries as a safe haven, and credit demand dries up in recessions when nobody’s really borrowing, so you’ve got all these factors now that pretty well would guarantee rates going down.”
How far down? Shilling isn’t ruling out a return to the lows of the summer of 2020. He thinks the flight to the suburbs that inflated housing prices in the first year of the pandemic is past its peak, with the housing market heading for a correction. He also fears a deeper crash for stocks after investors have spent years pumping the market values of meme stocks without regard for profits and with too much trust in aggressive SPAC projections. If 30-year Treasury bond yields drop from their current levels at 2.1% back to 1% in one year, that would result in a 30.7% total return–better than even the most rosy forecasts for this year’s stock market.
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