This article is based on a presentation from John Mauldin’s 2021 Virtual Strategic Investment Conference, which is being held from May 5 to 18. To register for this conference, click here. The Strategic Investment Conference was just approved by CIMA and CFP for 19 hours of continuing education credits.
The consensus is that U.S. equities will deliver strong performance as the economy recovers, and that higher inflation will drive rising interest rates. All of that is wrong, according to David Rosenberg.
The Toronto-based Rosenberg started his own economic consulting firm in January 2020, Rosenberg Research & Associates, after working a decade as chief economist and strategist at Gluskin Sheff & Associates. He was the opening speaker at this year’s Strategic Investment Conference, hosted by John Mauldin.
Before you place too much weight on Rosenberg’s analysis, recall that he delivered the opening keynote at this conference last year, when he proclaimed that U.S. equity market bulls were in “fantasyland.” He was wrong. The return for the S&P 500 for the last year was 56.25%.
The “fiscal juice” from stimulus checks and the re-opening of the economy are outstripping supply, creating temporary inflation. Supply will catch up when demand subsides as the effect from the stimulus wanes, according to Rosenberg. That will happen before the end of the year.
When the effect of stimulus checks expired last year, GDP declined by 2.5%. We will see a repeat of that this year, according to Rosenberg.
Inflation is not a temporary phenomenon; it is a process of ongoing acceleration in the price level. We don’t and won’t have a trend of inflation, Rosenberg said. Fed Chairperson Jay Powell will be right that inflation will be transitory, he said, just as deflation was a year ago when the pandemic began.
“The worst thing anyone can do is to extrapolate to the future,” he said.
Rosenberg recalled one of Bob Farrell’s classic market rules: When all the experts and forecasts agree, something else is going to happen. The consensus has never been more lopsided, he said, and that is reflected in asset allocations that heavily weight stocks relative to bonds.
We are not going have a redux of the prior century’s “roaring 20s,” despite the covers of many business magazines. Rosenberg said that era had nothing in common with today; the debt-to-GDP in 1920s was 10%, which allowed for declines in personal tax rates, which will not happen in the 2020s.
GDP declined 3.5% last year, which was the worst drop since 1946. A decline rarely happens two years in a row, he said, and we are having the expected recovery. There was a corresponding 5.5% decline in employment last year, but that means the economy gained in productivity. Productivity is an inflation killer, he said.
“We can produce more with less labor input,” Rosenberg said. Real GDP is now within a percent of its pre-pandemic high, but employment is down about eight million.
The economy is booming not just because of the re-opening. The critical piece was the government’s $3 trillion in fiscal support. There has been no organic growth, he said. “It has been largely a fiscal stimulus story.”
“How could we not have a recovery?” Rosenberg asked rhetorically.
When you strip out the government transfers, real personal spending is on a downward trend. The share of personal income from government spending is 28%; it has never been that high, according to Rosenberg. That is today’s “soup line,” he said, and it is temporary, based on borrowed money. Approximately 10% of the labor force is receiving government support.
Economic growth has been four parts stimulus and one part reopening, according to Rosenberg.
“We are basically 80% reopened,” he said. There will be no more incremental growth from re-opening.
There will be small growth form pent-up demand on the services side, particularly from travel and leisure. But that is an $800 billion sector in a $20 trillion economy, making it a recovery in only 4% of GDP. “We spent like never before on durable goods during the recession,” Rosenberg said, and that represents a $2 trillion sector that is up an unprecedented 12%.
Don’t count on growth from pent-up demand in the services sector, which he called a “nebulous concept.” Some services are lost forever, like demand for restaurants and haircuts that consumers have long since forgotten about.
At the same time, we are massively oversaturated on “stuff,” he said, from growth in durable goods.
The small growth from pent-up services demand will be offset by the bigger “pent-down” decline from durable goods, he said.
Other parts of the economy are in decline, according to Rosenberg, including commercial construction, exports (a $2 trillion sector), and travel and tourism. “There are big chunks of the economy that are not coming back that quickly,” he said.
Fed Chairperson Jay Powell is forecasting 6.5% growth this year, which is implies 2% growth in Q4. The consensus is 5% growth for Q4, according to Rosenberg. The earnings consensus is 10% growth, which he said is “not going to happen” with 2% economic growth.
“Earnings will disappoint,” he said, “and that is the principal risk for the markets going forward.”
Deflationary signs
Rosenberg went through a litany of data points supporting his thesis of low inflation.
He cited a survey of money managers that showed only 7% think inflation will be less than 2%. Searches for inflation on Google have never been greater. The inflation trade is “crowded,” Rosenberg said.
Inflation won’t come from commodity price increases. Most of the commodity demand has been financial and speculative. China is slowing its production because it is not stimulating its economy, and it consumes half of the world’s commodities. The positive returns for commodities will reverse in the second half of the year, according to Rosenberg.
Employment is still seven million less than the peak of the cycle. That excess labor supply is deflationary and will take several years to be absorbed into the workforce. There is no sign of wage acceleration, according to Rosenberg.
The University of Michigan consumer sentiment survey shows that inflation expectations are within the range they have been for the last decade, he said. The top concern of the small business sector is taxes; inflation and interest rates are the two lowest concerns.
Only 13% of those in a recent Barron’s survey were neutral to bullish on Treasury bonds, according to Rosenberg.
The break-even inflation rate is 2.5%, which was the peak rate in the last cycle, when unemployment was 3.5%. “I am not buying that,” Rosenberg said, implying that he expects lower inflation given the current U-6 unemployment rate of 11.1%.
The Cleveland Fed model is predicting lower inflation, he said. “The market is priced for peak inflation and for the Fed funds rate to go above 2.5%, which is higher that it was in late 2015.” That was when the Fed had to cut rates.
“That is why I am bullish on Treasury bonds,” Rosenberg said.
Productivity is an inflation killer, according to Rosenberg. Capital spending hit an all-time high during the pandemic, which will drive higher productivity. That, he said, is more powerful than a price push from commodities.
Not even demographics are inflationary. We are aging, he said, but that will not dampen demand for goods and services in the economy.
Public sector debt constraints have gotten worse, according to Rosenberg, but we know from history that is a constraint on demand and interest rates, and hence deflationary. The economy can’t tolerate an increase in debt servicing; a 1% increase in interest rates would cost 800 billion annually, he said.
Household savings have increased during the pandemic, which is also deflationary. Consumers are spending less of each subsequent stimulus package. A third of last stimulus was used to pay down debt, which Rosenberg called a new secular trend.
“The fundamental trend is that the natural rate of interest is going down,” he said. “Rates won’t go up with a secular move by households to get their balance sheets in better shape.”
Globalization, which acted as a constraint on inflation, is not dead, and global trade and export volumes are hitting new highs. Rosenberg said the disruption we are seeing in supply chains is creating inflation pressures. But we should not extrapolate that into the future. Ports in cities such as Los Angeles are full and containers ships are waiting to be unloaded. There will be a critical supply support in the second half of the year. Korea and Taiwan will alleviate the shortage in semiconductors sooner than most people think. Canadian lumber production is surging and will quickly catch up to demand later this year, according to Rosenberg.
Inflation is 1.5% or less globally, according to Rosenberg, and U.S. inflation has been 64% correlated to global rates. This too acts as a constraint on U.S. inflation.
Investment recommendations
Rosenberg concluded by offering some investment recommendation in the context of his low inflation forecast.
It is a good time for growth stocks, Treasury bonds, and rate-sensitive parts of the market, he said.
“What I am worried about is what nobody else is talking about,” he said. That is not inflation or supply shortages of goods, which will be remedied. We have a housing bubble, he said, although not as big as in 2006-2007. Houses are 20% overvalued relative to income and rent.
The Shiller CAPE ratio of 37 makes stocks the second-most overvalued in history, surpassed only during the dot-com era. That is a constraint on future returns, he said, and is consistent with 0% real returns for next 10 years.
He is also worried about the net worth-to-income ratio, which is at an all-time high. Rosenberg says it will revert too.
“That has me worried,” he said. “If that mean reverts, we are going into a recession.”
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This article is based on a presentation from John Mauldin’s 2021 Virtual Strategic Investment Conference, which is being held from May 5 to 18. To register for this conference, click here. The Strategic Investment Conference was just approved by CIMA and CFP for 19 hours of continuing education credits.