Larry Summers – Get out of U.S. Equities
“Be careful in the equity markets,” warned Larry Summers. The bond market is predicting a recession but, he said, the equity market has not priced that in.
Summers is a professor emeritus at Harvard University and a former secretary of the Treasury. He was a keynote professor yesterday at the Morningstar Investment Conference in Chicago.
The consensus economic forecast is for a recession, he said, but earnings forecasts have not incorporated that expectation. Yet the bond market is signaling danger. The yield curve and the Fed funds forward rates are predicting six or seven rate cuts in the next two years.
“That won’t happen without a recession,” he said, “and a recession is not priced into equities.”
The stock and bond markets are saying different things. That disjunction creates opportunities for investors, Summers said.
He said he would be short U.S. large-cap equities.
The danger of a recession is driven by the Fed’s policy in response to rising inflation and by weakness in certain sectors of the economy, such as commercial real estate.
The U.S. got to this point following a period of “secular stagnation,” a term that Summers popularized starting in 2013. The economy then was characterized by an excess of savings relative to investment. That kept interest rates low, slowed growth and drove down inflation.
To fix that, Summers advocated for fiscal stimulus (government spending) and for programs to increase household spending. But those programs were not big enough to overcome the stagnation. He claimed he “got it right” with respect to his description of the economy until COVID struck, which caused the federal government to increase spending to extreme levels.
Now there are excess federal deficits and a need to fund areas such as the green transition, which means less savings relative to investment. “We will not be in a situation of massive excess savings,” he said. “There is more risk of rates going higher.”
The inflation we are seeing was caused by monetary policy, according to Summers. The analogy he used was that the economy was like a bathtub that was mostly empty prior to COVID. But quantitative easing (QE) caused it to overflow, and the drains were not working properly, making inflation worse.
Summers predicted higher inflation two years ago for those reasons. But his view – that the primary cause was Fed-induced excess liquidity – is not universally held among economists. The alternative and equally compelling view is that inflation resulted from COVID-related supply chain issues, followed by surging consumer demand as the pandemic wore off. The shortage of goods and the surge in consumer demand drove prices higher.
Inflation will remain in the 5% range as long as the labor market remains tight, according to Summers. The U.S. went from 2% to 5% inflation over the last year, he said, “and the rest was just noise – like temporary spikes in gas prices.”
“It will be difficult to get to 2% inflation until and unless the economy slows down and the imbalance in the labor market readjusts,” he said.
What’s wrong with 4% to 5% inflation? The problem, Summers said, is that “people don’t feel so great.” Prices are rising faster than wages, meaning real wages are lower and purchasing power is reduced. People want clarity in numbers and specific targets like 2%, he said, “but they remember what you said, so specific forecasts are dangerous.”
Summers expects the Fed to raise rates by 25 basis points in its next meeting in May, as it has signaled. He predicted that the Fed will signal that it is “agnostic” about future rate hikes.
The problem, according to Summers, is that the Fed is not highly credible because it got “behind the curve” fighting inflation. It may need to do more to establish credibility. Summers did not specify what he meant by “do more,” but presumably that would be more rate hikes or aggressive guidance.
The Fed’s problem is analogous to adjusting the temperature in a shower in an old hotel. There is a 20-second lag until the water reaches the desired temperature. “It’s really hard to not scald or freeze yourself,” he said.
Summers cited the Oscar Wilde quote and likened second marriages and soft landings to the “triumph of hope over experience.” He cautioned that when inflation comes down, historically a significant economic downturn has followed. “If inflation gets close to 2%,” he said, “I will be surprised if there is no recession.”
It will not be a hard landing like 1982, 2008 or 2020, he said, “but even limited recessions affect the national mood.” Summers did not say this, but one inference is that this scenario would hurt President Biden’s chances of reelection.
The Fed’s challenge is more difficult by tightening credit conditions following the SVB crisis. That is restraining the economy, driving less need for higher rates. But it is not clear how much this will affect Fed policy and interest-rate increases.
Summers was not sanguine about prospects for the commercial real estate market, which is complicated by changed working and living conditions. It will be harder to borrow, property prices will fall, collateral will be worth less, lending will be constrained, rents will be driven down, and as valuations fall further, the cycle will perpetuate.
Expect there to be “tough stuff in the office-building segment,” Summers said, but the economy may be fine nonetheless. He likened the conditions to the late 1980s and early 1990s after the S&L crisis.
Working from home is “here to stay,” he said, “because lots of people like it.” Indeed, according to Summers, we run the economy to make lives better, not to maximize output.
“But it’s nonsense to say that everyone is more productive,” he said. He cited a noteworthy piece of anecdotal evidence, which is that weekday golf is way up.
Bet on the U.S.
Summers was bullish on the prospects for the U.S. relative to the rest of the world.
The collective value of U.S.-based companies as a percentage of the global markets is at its highest level ever and went from 40% to 60+% over the last two decades, despite the ascendancy of China. Those valuations are backed by future earnings and growth prospects, he said, so investors are betting on the U.S.
“Europe is a museum, Japan is a nursing home, China is a jail, and bitcoin is an experiment,” he said.
Investors must put their money somewhere, he said, and the “dollar is a pretty good place.” The U.S. has problems, “but overall, you have to be impressed by its record and prepared to think about the broader historical lesson.”
U.S. history has been full of what Summers called “self-defined crises.” In the 1970s, we feared the country was coming apart with the Vietnam War, Watergate, assassinations, he said, “but we came through it.” A decade earlier we feared that we would fall behind the Soviet Union in the arms race. During his presidency, FDR was told he needed to claim dictatorial power to win World War II. The fears underlying those crises were unjustified.
“We have the capacity and the resilience that comes from being alarmed and doing something about it,” Summers said.
Robert Huebscher is the founder of Advisor Perspectives.