The Soft Landing Dream
One awesome perk of my job is that I learn new things every day without even trying. Did you know the average stock in the S&P 500 is down in 2023? Also, no president has ever been re-elected when a recession occurred in the back half of his first term. The correlation between a president’s approval rating and gas prices is close to -100%. Men think about the Roman Empire on a daily basis, which is in-line with how often I think about soft landings these days. And yet, I didn’t even know that the term “soft landing” dates to the astronauts’ first landing on the moon in 1969. It was important that the lunar ship’s landing be soft, lest it wreck and be rendered unable to return to earth.
Economists soon redeployed the term to the Fed raising rates enough to cool down inflation, but not too much to wreck the economy. In the next four Fed tightening cycles (1969, 1973, 1979, 1981), the Fed failed to engineer a soft landing once. Lately there is a lot of ink spilled on whether the Fed is about to pull off a soft landing, with the consensus suddenly believing it to be a high-probability event. Interestingly, every news piece cites the 1994 Fed tightening cycle as the only one to end in a soft landing, giving short shrift to the 1984 Fed tightening campaign. We have long believed the Fed has a 2-8 record on soft landings since then, but it’s actually only 1-8? At any rate, one must wonder how many Fed chairs have wished the space shuttle had a hard landing so that the term stayed out of their domain.
Still, give them credit for sticking to their guns. They finally pulled it off in 1995! You might think, “a blind squirrel stumbles upon a nut every now and then.” Or, even pithier, “everything looks like a nail if you’re a hammer.” Raising and lowering the Fed Funds rate has been the lone tool in the toolbox, which explains why the Fed keeps using it. Until…the Fed discovered Quantitative Easing (“QE”) in 2008, which allowed them to borrow trillions in order to buy Treasury bonds and mortgage bonds, which helped keep long-term interest rates so low in the 2010s. More on that in a bit.
Let’s recall what happens to the economy when the Fed raises interest rates:
- Spending by consumers on durable goods that rely on financing, such as housing, cars, and appliances, is postponed or canceled, due to excessively high cost of financing.
- Businesses tied to those industries lose sales and profits, prompting them to cut workers and reduce investment in inventory and capital.
- Businesses pay more for interest, if loans are tied to floating rates (which rise/fall in real time as market rates rise/fall). At best, this reduces profits, necessitating cost cuts. Heavily-indebted companies could go bankrupt just because their interest costs skyrocket.
- Major capital spending and merger decisions by even healthy companies, if they rely on borrowing, are delayed or don’t happen.
- Consumers pay more for interest, if they have outstanding loans that are tied to floating rates. This crowds out other discretionary spending.
- Financial net worth drops as bond values drop. The drop in value is often accompanied by a drop in stock prices (as investors start to price in recession….1-8 record…), and often by a drop in home values. As net worth drops, consumers spend less.
That’s a lot of problems, so the Fed must be extremely concerned about inflation to invite all that pain on all of us. In that, you are correct. How does the Fed know when to stop? The challenge is that these effects can take 1-3 years to play out. The Fed must allow for this time lag, despite the vast amount of daylight between 1 and 3 years, and not wait until companies are laying off millions. You could finish that statement with “as long as the Fed is actually still trying to pull off a soft landing.” If we take Fed Chair Powell at face value, it sounds like he is inviting a hard landing. Let’s also remember that Powell thinks he can “jawbone” inflation down by sounding menacing. Or maybe when the Fed goes from 1-8 to 1-9 on soft landings, Powell can at least claim it wasn’t his fault because he kept warning us about a hard landing.
So why is everyone and their brother and Treasury Secretary now declaring a soft landing? The short answer is that we haven’t had a recession yet. Remember all those scary warnings in 2022 that the massive Fed hikes and ugly inflation numbers were going to send us into a recession? Reputed economists even predicted recession would start in 2022. The chart to the right shows mentions of the word “recession” on companies’ conference calls. Notice the peak in summer, 2022, and the 80% drop since. Our hypothesis was that as long as the consumer still had excess covid savings in the bank, and was still accepting price increases, we don’t need to talk recession
Does that mean we managed to sidestep a recession, dodge the bullet, stick the landing? (Lots of metaphors to unpack there, even a gymnastics reference). Suffice it to say we are highly skeptical. This seems like a good time to ask two questions. First, exactly how long does it take Fed hikes to cause recessions? Answer: recessions begin 1-3.5 years from the first Fed hike, and an average of 7 months from the last Fed hike. We are now 1 year and 6 months past the first Fed hike. Second, are there any special circumstances in this cycle that might be assisting in the push-off of recession into the latter half of that time range? We can think of 4 major factors present this cycle. Let us expand on each.
First, profits are down over the last four quarters, but not by much, maybe 5%. Profits drops of 10% or more tend to result in a lot more layoffs as companies really try to cut costs. Why have profits held up so well, in the face of higher costs for goods, higher labor costs, and waning demand in interest-sensitive sectors? Mainly because companies have been able to pass on most of those cost increases in the form of price increases, because the consumer has accepted them. Plus, companies, especially manufacturing companies, have a lot of fixed costs, which don’t go up (with inflation) until they need to be replaced. Then consider that company revenues include inflation. So, real GDP in the U.S. grew by only 2.1% last year, but 7.3% including inflation. Corporate revenue growth mirrors the higher nominal number of 7.3%. A company could grow volume 2.1%, raise prices 5%, have 15% higher goods costs, 8% higher labor, and still have flat profits, thanks to fixed costs like depreciation and interest staying fixed.
Second, as previously mentioned, consumers entered 2022 with $2 trillion of excess covid savings, which accumulated from government stimuli and consumers deferring spending on travel and entertainment. We always had faith in the American consumer that they would not have trouble frittering away those savings. Lo and behold, those excess savings are now mostly spent. It is not a large leap to the observation that that $2 trillion of excess consumer spending helped the economy a lot, and it won’t anymore.
Third, higher interest rates have so far been a boon for both businesses and consumers, not a cost. In this cycle, rates went up really fast, and you would expect that to result in a worse outcome than usual, but in fact, it is the opposite. For nearly all Americans, their mortgage rate hasn’t budged. Why? Because nearly all mortgages are fixed-rate, and pretty much the only reason you would have a higher mortgage rate is if you just bought a house. With existing home sales down 35%, that doesn’t apply to many people. The left chart on the next page, which goes back to 1995, bears this out. The blue line is the mortgage rate offered each month. The orange line is the average homeowner’s mortgage rate. You don’t see the two lines diverge much, until 2022:
Clearly, higher mortgage rates haven’t hurt many homeowners. Then consider the effect of higher interest rates that accrues to savers, who had been left to rot on the vine for 13 years (2009-2021) in the era of QE. Now the interest is rolling in. Let’s remember that this regime change in interest rates has hurt the low income cohort by far the worst, because revolving credit (like credit card debt) is typically floating-rate, not fixed. Rent typically resets (upward) annually, too. These are compounded by the exhaustion of stimulus checks and student loan payments restarting.
As for large companies, it is much the same story as for homeowners: not really hurt by higher rates. Overall, companies have seen a reduction in net interest payments as rates have shot up, as the second chart above shows. Reduction? Yes, because most large businesses have locked in low borrowing rates by issuing fixed-rate bonds, and because the interest income on their cash just went up 1,000% in some cases. True, small businesses typically borrow from banks. Most bank commercial loans float, though collateralized loans like for commercial real estate are normally fixed for 5 years.
Okay, so higher interest rates = higher income? By now you have probably joined the “soft landing” club…corporate America seems to keep coming out ahead.
Fourth, and finally, the labor market has not weakened. Businesses were short workers even before the pandemic, but covid sent a lot of workers to the sidelines. The chart to the right shows job openings in the U.S. Notice how they shot up in 2021; for awhile there were twice as many job openings as people looking for jobs. Fast-food restaurants were offering signing bonuses.
The number has faded in the last year from 12 million to 8.8 million, some due to growth in labor supply actually filling those openings. 1.9 million laborers have entered the work force in 2023 alone, and wages have gone up 5%. That has helped support consumer spending growth of 7% this year. The conundrum facing the Fed is whether to focus on the recent descent of the line, or whether to emphasize that it is still 2 million above the pre-pandemic level.
The second chart below, actually two for the price of one, shows the labor force participation rate among the two primary labor cohorts: ages 25-54 and 55+. If you find yourself wondering “where are the workers,” this chart should clear things up pretty quickly. Yes, there was certainly a group of prime-age workers who chose to live off the expanded unemployment benefits for awhile, but now that those are long gone and it’s 2023, you can see that the participation rate is at a new cycle high, higher than pre-covid. For the 55+ set, however, participation briefly rose in 2022 as covid was waning, but has since dropped back almost to the covid lows.
Clearly, “The Great Resignation” has been a lot more apt a description for retirees than couch surfers. The problem with this is that it’s a lot harder to convince a retiree to unretire than to convince a couch surfer to go back to work. The one proven factor that has historically moved retirees back into the work force is the one we don’t want: a nasty bear market in their IRAs.
By now you’ve probably picked up on the theme here: the economy has been surprisingly resilient this year, but for reasons that will likely either disappear or turn negative. Consumer spending will struggle to grow, and companies will lose pricing power, but if wages continue to grow 5%, profits will drop, causing layoffs. More fixed borrowing costs will reset higher, as bank loans and bonds mature.
It seems that this all comes down now to the labor market. Hiring needs to continue to be strong, and wage growth strong enough for the consumer to keep on spending, and keep the top-lines growing. But not so strong that businesses slow down hiring. The labor market truly needs to thread the needle into the Land of Goldilocks.
The Case for Goldilocks Astute readers of our newsletters will remember that we wrote a Goldilocks white paper in 3Q 2016, because the 2010s were truly a decade of a Goldilocks economy. To refresh, she is a euphemism for the economy being “not too hot, not too cold.” While she stepped away from the limelight for a few years, she has returned as the face of the soft landing.
The Fed saw its path to a soft landing when it began raising rates in 2022 as killing job openings without killing jobs. This relied on two premises: 1) too-hot wage growth was caused, in part, by desperate businesses paying up to secure much-needed workers, manifested in the moonshot job openings number, and 2) as the Fed raised rates, companies would reduce job openings linearly before they reduced jobs. So far, both of these look to be reasonable bets. The job openings report has been critiqued on many levels, but still seems like a solid leading indicator to jobs. That said, the Fed probably expected that number to be far lower by now, like back under 7 million.
The Fed’s task in assessing the job market has now been made vastly more complicated by union strikes. We’re all a little edgy waiting for what the Big 3 automakers will agree to, especially given the outlandish demands made upon them by the UAW. Most clients know that we pretty much never buy automakers or airlines for their boom-bust nature, but it is wise to pay attention to what the Big 3 do in this negotiation. While the old saying is true that there are “lies, damn lies, and statistics,” we must believe that the automakers are not fibbing when they say they lose money making EVs (electric vehicles) and they won’t need as many workers to make them. The UAW’s primary leverage is the tight labor market. If you look at the history of UAW strikes over the years, particularly for GM, they always seem to occur just before recessions, because labor markets peak right before recessions begin. It’s hard to find scabs to work in the factories when surplus labor supply is nonexistent. Perhaps the Babylon Bee summed it up best with the headline, “Auto CEOs struggle with whether to replace workers with robots or Mexicans,” a reference to moving production from the U.S. to south of the border.
The reason we’re watching how this plays out is because it’s probably a pretty good tell on where the labor market really is in real-time. The UPS settlement wasn’t quite as good a tell because UPS can largely pass on its cost increases in the form of price increases. The Big 3 cannot, especially as they compete with the likes of Tesla more and more. Tesla is non-union.
So what has to happen for Goldilocks to live on? Put simply, the stars must align. Job openings must continue to vanish, while companies continue to hire people. Labor supply needs to fill that void, as in new entrants to the workforce, who haven’t been working until now. That could be recent college graduates, immigrants, middle-age folks rejoining the work force, or retirees rejoining the work force. These are netted against people leaving the work force, of course. At the same time, companies pass along Goldilocks-endorsed wage growth in the 2-4% range to their continuing workers. Anything more could lead the Fed to keep raising rates, or lead companies to hire fewer people if they have less success in continuing to raise prices. Anything less would mean that workers are likely continuing to fall behind inflation, as they have for the last 2 years. Then those potential concerns about the consumer—covid savings are gone, high financing cost, inflation a major annoyance—become real concerns for consumer spending.
Plus, there are a lot of other factors that have the potential to scotch the Goldilocks story:
- A resolution of the UAW strikes much in favor of the union could embolden other unions and employees wanting to unionize.
- Rising gas prices
- The imminent ending of covid emergency funding for day care centers
- The surge in violent shoplifting causing retailers to shut down stores
- The risk of a government shutdown will resurface by November 17. A shutdown is generally an overstated risk to the economy, but amidst the rest of this list, could exaggerate other problems.
- The massive federal government deficit, still at $1 trillion despite a solid economy, should only go up as outstanding Treasury bonds mature and get reissued at higher rates.
- Finally, bank credit has suddenly tightened since the “bank crisis” in March, as banks reposition balance sheets to keep more cash instead of making loans, and with the threat of higher capital requirements from the FDIC looming over them. The chart on the next page shows the % of banks tightening lending. It is now over 50%, up to levels that in the past (1990, 2001, 2008, 2020) have been followed by recessions:
By now, in this emotional ping pong rally of a newsletter, you might be glum on the economy’s prospects, or you might be feeling Jim Carrey in Dumb and Dumber, “so you’re telling me there’s a chance…” Either way you should have a realistic lay of the land. We expect companies to continue to deploy more automation tools, including AI, as a means to substitute labor for capital, which should help them cut (labor) costs to some degree. But by the same token, it’s hard to envision corporate America paying a lot so that they can cut costs, especially with financing costs so high.
Long-term interest rates have sharply risen since July as the soft landing narrative has prevailed. At some point, the yield curve should un-invert, and that’s historically the time that the stock market performs the worst. If the curve un-inverts because long rates keep going up, those higher rates will cause more problems in the economy. If the curve un-inverts because short rates fall dramatically, it will be because the Fed is cutting rates because the economy has already weakened. Asking the yield curve to stay inverted for more beyond 1 ½ years is crazy. But then again, the world is a little crazy too. Our conclusion: the market might still buy into Goldilocks: The Soft Landing for some time, helping to maintain enthusiasm for stocks. But looking out further, this doesn’t seem like the best time to be in the stocks which have the most downside risk.
- Written by John Meyer