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This is an abridged conversation from Seeking Alpha’s Investing Experts podcast recorded on May 10, 2023.
- 1:10 – Real-time inflation metrics
- 7:30 – Q2 not a very good earnings quarter for most companies
- 10:10 – Yield curve a fairly reliable indicator of where economy is heading
- 19:20 – Sticking with a defensive portfolio
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Transcript
Daniel Snyder: Inflation numbers came out this week. We just got the report. What’s the initial takeaway?
Eric Basmajian: So, inflation is decelerating, right? The rate of inflation is coming down. And I like to look at most of the data on a six-month annualized basis. It tends to be the sweet spot because when we’re dealing with a fast moving economy, or a market, year-over-year can kind of take a long time to filter through. The month-to-month stuff is a little bit too noisy. So, if we look at it on a six-month basis, it tends to be a fairly smooth representation of the trending direction, which is really what we’re trying to capture.
And inflation on a six-month basis has cooled from a peak of about 10% to the 3% range now. So it’s certainly come down pretty aggressively. It’s not quite back at the Fed’s 2% target yet. But what’s interesting is, if we take the total CPI and we just strip-out the shelter component, which we know has that lagged effect, then inflation is about 1.2% over the last three months – three-month annualized.
And that metric, CPI less shelter has averaged about 1.4% over the last eight months. So, if you remove the shelter component, inflation has actually normalized back to 2%, and slightly below 2%, for about 8 months now. But of course, we can’t exclude shelter because the Fed looks at it and it’s part of the metric. So when we do that, it puffs the number up back to above where the Fed wants it to. So, I think overall there is more than sufficient evidence that the Fed has broke the back of the inflation that we were experiencing, the numbers are trending down.
And if you strip it down to try and make it a more real-time measure, they’ve certainly accomplished their goal of getting it back to 2%. Now, it’s just a matter of trying to hold policy in a restrictive stance until that shelter component can kind of filter all the way through, without allowing some of the progress that they’ve made to reaccelerate.
Daniel Snyder: Do you have any thought on how long they’re going to need to keep interest rates where they are going forward in order to achieve that?
Eric Basmajian: Everyone at the moment is looking at the CPI to make the assessment of how long the Fed’s going to have to hold rates. But when we go back across history, and you look at almost every recession in the past, the Fed is aggressively cutting interest rates when core inflation is 4%, 5%, 6% because it’s always a market-driven event that causes the Fed to have to snap into action and start cutting.
At that moment, when the market seizes up, equity markets are falling precipitously, commodity prices are falling precipitously, they’re not — at that moment, nobody’s worried about inflation anymore. People are worried about their jobs. And even though the headline numbers are still high, everybody knows that inflation expectations are plunging. So, it’s really a question of when does the market sort of seize up with a credit event type moment.
And a lot of people keep saying, when is the credit event going to come? And we’ve certainly had a handful of them so far. They just haven’t been sufficiently destabilizing yet. So, the impetus for the Fed to really pivot so to speak is never really driven by employment and inflation, those are usually after effects of the market event that’s transpiring because of some of the more leading elements of the economy that we usually discuss.
Daniel Snyder: Now you’re painting a very rosy picture, right? It almost sounds like if somebody’s out of the market in cash at this moment in time – should people be fully invested right now?
Eric Basmajian: So, they’re breaking the back of inflation and we can see that in the real-time numbers. Now they obviously have to hold the policy here. But the decline in inflation is happening as a residual effect of the economy slowing over the last couple of years. In 2022, GDP growth was 0.9%, right. This is a very weak growth that we’ve had. And some of the more cyclical areas of the economy are under even more pressure than that, in a recession of their own already. So the reason that inflation is coming down is not necessarily for good reason, right?
So we have the inverted yield curve that doesn’t predict recessions as much as it does mechanically cause them, right? It’s both predictive and causative because banks can’t borrow short and lend long. So if banks are rendered unprofitable, they can’t extend new loans and new credit to the economy and you get a pullback in credit.
And then the inflation rate starts to come down. And we’re seeing the early signs of that and to the extent that the Fed holds rates where they are, which for the time being that seems to be the plan, that process is going to stay in motion and actually intensify. Because even if the Fed doesn’t continue to ratchet up the rates, they’re still at a level that’s very restricted if they just hold them where they are.
So, this downward momentum that we’re experiencing in the economy and is starting to now flow through the lagging inflation components, is not a good thing for corporate earnings and soon to be broader employment. We can maybe touch on some of the employment numbers, but we are seeing job losses on a pretty consistent basis in some critical sectors of the economy. So, that’s likely to persist and those things are likely to be negative for corporate earnings, which will be reflected in the quarters to come.
Daniel Snyder: In regards to what you just said about corporate earnings, right, this restricted policy is going to hinder corporate earnings. We’re just coming out of earnings season where we saw a great number of beats and raises on guidance. So, is it here on out that investors should be worried? Was the last quarter the last good quarter?
Eric Basmajian: Well, I think it really depends on what parts of the market that you’re looking at. Right? We can look at micro caps, small caps and large caps, right? Micro caps would be — your most economically sensitive. You could think of them — closer to mom-and-pop type businesses. Then you have your small caps like the Russell 2000 which represents 2000 stocks, but they’re not quite as big as Apple, Microsoft and Google. And then you have your large caps, the S&P 500, which is dominated by those 4 or 5 companies.
When you look at micro caps, they have actually made a new low below their October 2022 lows, down way over 20% from the peak. So, it has not been a good ride for micro caps. If you look at the Russell 2000, they basically have made a new low relative to their October peak as well. They hadn’t recovered at all. Down about 20% as well and likely to keep trending that way. So for large parts of the market, this has not been a very good environment and earnings season was not that helpful to that.
But when you go to the large cap S&P 500 sector, then you’re starting to see some decent performance, specifically off that October low, a lot of that has to do with the fact that the recession hasn’t proliferated to the most insensitive companies, which would be your Apple (AAPL), Microsoft (MSFT), and Google (GOOG) (GOOGL). And also because you’ve had some reprieve on interest rates where they’ve come down from 4.5 to 3.5 on the 10-year. And a move in interest rates like that tends to be more helpful to those bigger companies as opposed to the smaller companies.
So, I think under the surface, this was not a very good earnings quarter for most of the companies that represent the stock market and they’re actually sitting at new lows for these broad, large conglomerates of stocks. So, I think that that progression of micro caps to small caps to large caps is very consistent with what we see across history. I would remind you with just one anecdote that in May of 2008, which was six-months into what everyone would consider a bad recession, the S&P 500 was 8% from its all-time high.
So, these large, somewhat non-cyclical service oriented stocks that have become essentially monopolies aren’t always the best forward looking indicator of the economy, but some of the more cyclical sectors still are.
Daniel Snyder: For the investors that are looking to get a gauge on the market, what are you recommending that they look at? Is it the 10-year yield? Is it the inverted yield curve? What do you think?
Eric Basmajian: So, I think the yield curve, if you were to have to pick one measure, is a fairly reliable indicator of where the economy is likely to head, because I mentioned, it’s not just predictive, but it actually also causes a recession by rendering financial institutions unprofitable, thereby slowing lending growth and the broader economy thereafter. It’s always difficult to boil it down to one measure.
But if I had to, I would say the yield curve would be a fairly reliable indication that you would use to perhaps allocate towards stocks or assets that will generally trend up over time and do well when the economy is in a period of expansion, but really trying to avoid the sort of nasty drawdowns that come with some of these risk assets that always tend to cluster around recession periods.
So, if you had to boil it down to one, I think the yield curve is a very good measure and the depth of the inversion today is pretty alarming, and the duration of the inversion, so how long the curve has stayed inverted. Two extremely reliable signals that the economy is either in recession now or soon to be in the coming months.
Daniel Snyder: Well, and that’s the question, right? So, what’s your answer to that? Are we in a recession now? Or is it coming in the months?
Eric Basmajian: So, if you have the job of trying to time the recession in real-time or data it’s very difficult because data comes with a lot of revisions. Right? So revisions can be huge around inflection points, which is the months leading up to a recession. For example, it’s not impossible, and this happened in the 2007 cycle, where the first GDP number is reported at something like positive 2%. And by the time the third revision and benchmark revision comes in, it was actually negative 1 or negative 2. Meaning that it can be off directionally in magnitudes that are very sharp.
So the data that we’re seeing today, we have to take it for what it is, but we also have to assume there will be revisions to this data. Right? One rule of thumb though is, the revisions tend to come in the direction that the economy is trending. Right? So if the economy is accelerating and moving higher, like it was coming out of the COVID period and in 2020 and 2021, the revisions tend to improve the data when you look at it in hindsight.
But as the economy has been slowing down as it has been and the growth rate starts to get close to 0, and it looks like the economy’s momentum is pushing it towards recession, these revisions are almost always to the downside. So we have to take the data at face value. Right.
The second problem is that the indicators that everybody likes to look at when they talk about recessions, which is usually consumer spending and various measures of the employment market, Those 2 measures don’t look recessionary until about 1 or 2 months into the recession. And then the data is reported with at least a one month lag.
So, if you’re going to be looking at employment or consumer spending, you’re really not going to see it until 3 or 4 months into the recession. And that’s assuming that that data is correct because if you are in a recession, it’ll be revised even lower than what it was reported, right?
So the only thing that we can do to try and make a real time determination is, go by leading economic indicators and then take a basket of 6 of them or 10 of them that have proven consistent across time, stack up where they are today and what they look like in the first couple months of recession. And when we do that, the evidence to me is sufficient to say that there’s a very strong likelihood that when the NBER goes back to date this recession, it could very well be a Q1 start, maybe a Q2 start. It’s really hard to say. It depends entirely on how these revisions come through.
Daniel Snyder: Eric, you just teed this up better than I ever could have, Okay. So you were talking about the revisions. You’re talking about the possibilities of recession. We’ve been talking about employment. We got the employment numbers. You put out this great article under EPB, I read your articles every week. I love the research you do. But, like, you talk about how they already revised down the employment numbers of February and March, if you’re talking about revising down being in the recession, is that one of those indicators? That sounds like a checkbox.
Eric Basmajian: Yeah. That would certainly, you know, every data point that comes in, you sort of revise your thesis and say, okay, did that data strengthen my thesis or weaken my thesis? And that data certainly strengthened the thesis because downward revisions to the economic data is the rule when you’re in recessionary windows. It’s not the exception. So, the fact that we had substantial downward revisions, like you said, checkbox in terms of confirming the path that I think that we’re headed on.
So, the prior two months were revised down by 150,000 in total, very substantial. But more importantly to me is, when the economic data comes in, the headline jobs numbers will not show that the economy is in recession, on average until about 3 months into the recession. If you go back to the 1974 recession, you didn’t have a negative headline jobs number until eight months into the recession.
And then it’s reported with a lag, so you would have got that information basically 9 or 10 months after the recession already started. So, the headline jobs number is not the best barometer because education and health services virtually never lose jobs, not even in recessionary periods, and then there’s a host of other sectors like the government that are super non-cyclical and just don’t lose jobs in recessionary periods on average.
The sectors that drive almost 100% of the job losses are what I would define as your cyclical sectors. So that’s your construction, your manufacturing, your temporary health services and maybe your trucking and transportation, things that feed into that durable goods sector. And a lot of people will now say, well those sectors are becoming an increasingly small share of the economy, services is 80%, why don’t we focus on services?
I wrote an article about this and the answer is because services employment declined ahead of recessions, zero times. So, it’s never going to decline ahead of recession, the month the recession starts, or even 2 to 3 months after the recession starts, you’ll never ever see it if you look at the services employment.
The second thing is that even though the cyclical sectors are becoming smaller and smaller, data shows that they still drive vastly more than 50% of the job losses during recessionary periods. Even during the 2008 recession, which came with very heavy job losses in financial services, the cyclical sectors still had more job losses than the service sector. So, you have to focus on the cyclical sectors if you want to kind of get the forward-looking read on the momentum of the labor market.
And when you do that, when you combine the construction, manufacturing, trucking and temporary health services, that makes up about 22 million payrolls, and those sectors on a 3 month basis to smooth out some of the noise has lost jobs for 5 consecutive months.
So again, you take the downward revisions to the headline number, you take a very consistent string of job losses in the cyclical sectors, and then you stack that up with some of the more forward-looking measures like the inverted yield curve and the rest, and it paints a picture that the economy is likely in the early stages of a recession and if not very close to it. It’s always tough, like I said, without the revisions to get super precise. But for asset allocation purposes, I think the timing whether it’s Q1 or Q2, isn’t overly important.
Daniel Snyder: And so the thought here is that, manufacturing is where you actually want to look, but all the media wants to talk about is the tech layoff because that’s probably what’s gets clicks. Right?
Eric Basmajian: Right.
Daniel Snyder: So with us potentially being in a recession right now or going into a recession, portfolio allotment, what are we looking at here? You’ve been staying defensive for a long time. Is now the time to flip? Like historically has it been, buy heavy in the recession for when we eventually exit?
Eric Basmajian: So, no, I’m sticking with the defense. And to that point, these large cap tech stocks that have driven the rally would be expressions of defense, right? Those are sectors that generally benefit from cyclical downturns in relative sense.
So the sectors that I’ve been encouraging people to avoid would be your financials, your small caps, your cyclicals because those are the sectors that relatively underperform while your low beta, low volatility, things like your utility sectors and then your large cap technology, those if you’re looking in the equity universe do tend to be your expressions of defense. You’d absolutely want to be with large caps over small caps. You’d absolutely want to be with low leverage stocks over high leverage stocks or high balance sheet debt stocks.
So in the equity universe, those are the allocations that I believe will relatively outperform. I prefer gold over its industrial metal counterparts. Gold could decline in a recession, it’s common. If you have a bout of deflation, gold will certainly decline, but it’s likely to hold up better than its industrial counterparts like copper and oil. Those tend to have more economic sensitivity. So if I was looking in the commodity universe, I’d want to have a preference for gold, over the economically sensitive commodities.
And then what I was looking in the fixed income market, I wouldn’t want to be taking credit risk. So I’d want to be withholding treasuries over corporates because the spread between the two them will likely widen out in a recession and you can be distributed across the curve in terms of duration, depending on your appetite for risk and volatility. If you just want to — if 5% is good enough for you and you want to tuck it away in T-bills, that would be a very smart thing to do.
But if you want to try and profit from a recession in a more substantial way, then you’d want to be looking further out on the curve to ETFs like (TLT) and those securities which could rise significantly if the Fed does have to lower interest rates back to levels that we’re used to before COVID. So those are kind of the general portfolio themes that I would be using in the environment that I think we’re headed to or which is the maturation of what looks to be an early recession here.
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