Please Sir! Can we just get on with the ‘Big R’ Recession?
Investors grow impatient waiting for the big downturn that may never fully come.
As we sit here in mid-May, it strikes us that most everyone we meet fully anticipates hard times ahead. The only question seems to be when. This summer? In the fall? Possibly next year? Many are growing frustrated that the widely broadcast doomsday scenario keeps getting pushed back. One day we get a weak print, the next day a strong one. Last Friday’s University of Michigan consumer sentiment survey was weak but today’s April retail sales report offered yet another sign that while the consumer has pulled in his reins a tad, he’s still spending. Will he ever crack? Yesterday’s Empire manufacturing index was awful but today’s industrial production number came in hotter than expected. And the banking crisis everyone keeps anticipating seems to wax and wane, with the pace of problems rising to the surface so far coming much slower than the meltdown of 2008. Each successive problem, spaced by weeks not weekends, is smaller, not larger, than the last. So where are we? Are we going to get on with this recession or not?
Not to sound like a broken record, but at Federated Hermes we continue to believe we are already in an asynchronous slowdown, which we are calling a “Rocky Landing.” And for those hoping for an alarm bell to go off or a siren to sound announcing the “All Clear,” we’d advise that Godot may never blow through the front door as dramatically as they expect—or come at all. This slow-motion slowdown/recession still has many months to go and navigating it successfully will take patience. The good news, in our view, is that many stocks already reflect at least a modest recession “on the horizon,” so in that sense, they have been de-risked for a Rocky Landing. But upside beyond dividend payments could take some time to unfold.
Taking a fresh look at some of the key areas of angst we are all hearing about, here’s some perspective on each that might help:
- The government debt “crisis” Given the political drama involved here, it’s no surprise that as headlines every morning scream “U.S. government debt default coming,” most Americans are yawning. They’ve seen this act play out 78 times since 1960 and it always ends the same way. We agree with them. The reality is that interest payments on the U.S. debt currently account for less than 15% of federal outlays, and although Treasury Secretary Yellen is being a little cagey about just “when” she will lack sufficient cash to pay that interest, our guess is the point is a lot further off than she lets on. Although in a crunch the other obligations of the government could get temporarily hung up (think “IOUs” to contractors, payroll, even Social Security recipients), an actual debt default seems extremely remote. And should the stalemate extend long enough to force a government worker furlough, for instance, our guess is not long after, President Biden and Congress would be forced back to the compromise table. No one wants unemployed government workers on their backs during an election cycle.
- Consumer debt “crisis” Another big worry out there is that consumer debt, which has just reached a new high at $17 trillion, is about to sink the economy. Here, we differ from the bears. While we see the debt level as a drag on growth over the next several quarters, we also think a crisis is unlikely unless unemployment suddenly spikes. For one thing, as large as the debt pile is, 71% of it is actually safely stashed away in mortgages, much of it of the long-term, low fixed-rate variety. Mortgages are helping consumers on balance, not hurting them. As for the rest, delinquencies are rising on credit cards and auto loans, but that process is happening slowly because employment remains strong and as long as consumers have a job, they tend to pay their bills. Indeed, while off 2021’s record low, household debt service as a percent of disposable income is still at historically modest pre-pandemic levels. Meanwhile, the banking system is gradually building up reserves to fund consumer credit losses, if and when they come. So, absent a sudden economy-wide downturn that causes unemployment to spike quickly, the consumer debt load is probably more likely to play out as a drag on spending and growth ahead—part of the rocky landing.
- Corporate debt “crisis” The good news about corporate debt levels is that much of it is termed out over long horizons at low rates—maturing loans don’t peak until 2025—and backed by businesses generating significant levels of cash flow. For sure, there are problematic pockets but even here the effect is more likely to be a slow-moving drag on growth rather than an immediate bell-ringing crisis. Commercial real estate, for example, is a problem for sure but less than 10% of the market is actually in office buildings, including problematic Class B and Class C buildings. Many of these loans will have to be restructured or written down over the next four years as leases turn over and borrowers can no longer support the loan payments. But again, these adjustments are likely to occur over time, rather than all at once in a cloud of smoke. A drag on growth, but not a crisis.
- Regional bank “crisis” Of all the worries out there, we come closest to agreeing with the markets on this one. While most regional banks are very conservatively run, with near-matched duration books, high levels of insured deposits, strong capital bases and loans backed by well-understood local businesses with strong cash flow levels, there are exceptions and the shorts are gradually going after the latter, one at a time. The effect has been to cause many regional lenders to pull in their loan officers, with a palpable credit tightening squeezing small and mid-sized businesses around the country. The good news is that the pace of problem banks has been relatively slow and steady, and successively, the sizes of the problems are getting smaller, not bigger. So here again, for now at least, the impact seems to be more directed at slowing growth than creating a full-on, systemic economic pullback.
- Earnings “crisis” Here again, the entire market seems to be “waiting for Godot.” The recently completed earnings season did produce another in a series of modest contractions, but the 2.6% decline was much less worse than the 8.2% drop consensus had expected. And to be fair, we’ve been even more bearish on earnings than consensus, expecting a full-year decline of 15% on S&P 500 earnings to $190. Our guess following the just-completed season is that this number may be too low and needs to be revised higher. We’ll see.
When you add this all up, it strikes us that while a crisis could be about to happen, what’s far more likely is more of the same rocky landing we’ve been getting since this bear market in stocks began 16 months ago. And here’s what’s really interesting if this is right: markets, worried about a full-blown recession, may already have discounted a mere rocky landing. For instance, many industrial bellwethers are 20-30% off their peaks—not the kind of declines they’ve seen in a near-death experience like 2008 but pretty substantial. The entire regional bank index—inclusive of a few problem children, for sure, but also of mostly healthy survivors—is now down 35% from its peak, with many stocks trading at or below book value. Big, diversified and relatively stable dividend-paying stocks in telecommunications, energy and pharma are sporting PEs in the low double digits (or lower) and dividend yields between 3-to-5%. Bitotechs, under pressure on the funding difficulties and credit crunch discussed above, are 50% off their highs. Many big retailers, in the news this week with their quarterly earnings, also are priced for hard times ahead: Home Depot, which disappointed modestly, is now off 16% from recent highs and trading at 18x earnings; Target, which plummeted 40% at the beginning of this bear market in February last year, has been stuck in the mud for months. Even within the currently hot large-cap tech space, relative bargains are still to be had. Google, for example, is still down 20% from its highs and is trading at 19x forward earnings. Not cheap, but not crazy given its strong balance sheet, near monopoly position and potential for growth from its artificial intelligence push.
All in all, while the outlook is not terrific, it seems to us that the next several months are likely to be less worse than feared. And that could be good enough, particularly for picking stocks among the hard-hit value indexes where dividends abound and cash flows are solid. As the year progresses and the rocky landing’s end begins to rise above the horizon, we may even add to stocks. If we’re right, and the Recession with a big “R” never comes, stocks are likely to grind higher before 2024 arrives.