Title: A Mid-Year Conversation on the Economy
Abstract: In this special mid-year podcast, Rob is joined by MFS Chief Economist Erik Weisman to discuss all things around the economy, including the rate of inflation, probability of recession and other trends that may affect the financial markets and assets.
Rob Almeida: Hello, this is Rob Almeida, Portfolio Manager and Global Investment Strategist at MFS and host of the MFS Strategist Corner Podcast. In this episode, I'm thrilled to be joined by frequent guest and Chief Economist at MFS, Erik Weisman, where we discuss all things inflation, the economy, recession probability and most importantly, outlook for financial markets and assets. I hope you enjoy this episode.
Disclosure on screen/spoken: The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.
Rob Almeida: Erik, welcome back.
Erik Weisman: Thank you, Rob.
Rob Almeida: Where is the recession?
Erik Weisman: Where is the recession? This is the big question.
Rob Almeida: I've looked under the rug. I've looked under my bed.
Erik Weisman: Behind the couch.
Rob Almeida: Where is it?
Erik Weisman: It seems to be nowhere to be found. And even beyond that, as you might be waiting for it and saying, "Yep, it's coming, it's over there and we're going to get there," and that runway seemingly keeps elongating. It's like one of those horror movies where you see one of the protagonists running down the hall and the hall keeps getting longer and longer and longer. So even most recently, as we look at revisions to GDP, GDP revised up, we look at initial claims, they've rolled over, we look at durable goods, they're hanging in, the consumer is hanging in. You would have no idea that there was a mini banking crisis. Doesn't really appear to be having that much impact on credit. And full steam ahead, despite seemingly an awful lot of forward-looking indicators that would suggest otherwise. So still think it's coming, but when remains a mystery.
Rob Almeida: Well, it seems to me that's what risk assets are anchoring to, and we'll get into that. But going back to those forward-looking indicators, walk through the signals that you see, and you've talked about this internally, but the amount of signals and the magnitude are certainly screaming something different than what, maybe, the real economy is showing us in the visible data.
Erik Weisman: So, if you look at the shape of the curve, people love looking at tens over twos. It's been inverted for a long time. That doesn't have a perfect track record. But if you look at something that includes a shorter end of the curve, so 10s over 3-month, or you look at 3-month spot versus 3-month, 18-month forward. So that gives you a sense that in the shorter term, interest rates might be lower than they are right now. Those curves are highly inverted. They've been inverted for a long time. That almost has a perfect track record post World War II would suggest very strongly there should be a recession somewhere down the line.
Now, if you look at prior episodes, curve inversion tends to give you a pretty long heads up. And the length of time that we've been inverted here isn't particularly unusual in terms of not yet seeing recession, but it still strongly suggests recession. Obviously the Fed raising rates 500 basis points, you're going to have a hard time finding another episode where the Fed tightened that much that quickly and allowed its balance sheet to roll off, and all the other central banks in the developed world except Japan are doing the same thing, where that doesn't result in major weakening in growth and probably a recession. You can look at monetary aggregates. So M2, M2 year-on-year is negative. We haven't seen that really since probably the 1940s, 1950s, Leading Economic Index has been negative for 14 months in a row. You will never have seen that from the 1950s on without either being on the cusp of or in recession.
All of these things, if past is prologue, would suggest that the recession's coming. We just have to be patient. And we've been impatient. The Fed has been raising rates very aggressively. Other central banks are doing the same. We're allowing the balance sheet to roll off, which is a different way to tighten monetary conditions. And we think, "Gosh, this should be enough to give us the recession. Why isn't it here yet?" Well, it's because raising interest rates takes time to hit the economy. Think about contracts that are signed, there are 12-month contracts, 18-month contracts, 24-month contracts. You can raise rates an awful lot. You might not be impacted for that 12 to 24 months. And that's kind of the window that we're entering. So, I think we are being impatient. I think it's going to happen, but the macro data that we're looking at right now, the instantaneous macro data suggests it's not imminent.
Rob Almeida: What about the strength of the labor market and in the context of everything you just talked about, the durable goods number, the falling unemployment claims, revised GDP. Has the Fed or maybe global central banks done enough? So, combination of perhaps were being impatient or have they not done enough or both or neither?
Erik Weisman: So again, based on the past, I would say they've done enough. I think the central banks are also impatient. They don't want to lose the narrative. They don't want to lose their inflationary anchor. They know they have lost some credibility by having gotten this wrong and allowing inflation to get out of the box and saying, "Oh, it's transitory." Clearly, it wasn't that transitory. And they're not going to wait for that kind of 12 to 24 months to elapse to see the weakness. The longer that we have robust labor markets, inflation that gets stuck at too high of a level, the more I feel like they're going to press. And we've seen even in just the last handful of weeks, several central banks have had their meetings and they have been more hawkish than expected and anticipate that they will continue to be more hawkish. So, either their right to do so because the labor market isn't weakening and inflation isn't weakening, or they're making a policy mistake and that they're not being patient the way that they might have been in the past.
Rob Almeida: Right. So, if we come back to the labor market again, and the strength of it, it's ultimately incompatible with getting inflation to use your term back in the box. And so how do you maybe square that circle?
Erik Weisman: So, it should be the case that if the labor market is strong, income generation is strong, that allows the consumer to spend, that should keep inflation higher than it would be otherwise, and that's not getting the Fed to where they want to be. So, it should be the case that you've got to weaken the labor market in order for the Fed to meet its targets. So why is the labor market so strong? Some of it has to do with sort of the shift as we went from pre-pandemic to the worst of the pandemic to kind of the pandemic is fading to post pandemic. You're hiring a lot of people in some areas, you're firing people and others, and then you're reversing it all. So, some of it is a labor market that's very much in flux.
The part of it that I think is the most befuddling though is if the productivity numbers are correct, and they almost certainly aren't because they're revised up, down and sideways over the course of time. But the productivity numbers right now would argue that people are being very unproductive overall. You are hiring people for negative productivity. That should hit profit margins for companies, but we're not seeing it. So, you're paying people an awful lot of money in wages essentially to do negative work. This doesn't make a whole lot of sense.
Rob Almeida: Yeah, negative return.
Erik Weisman: And it gets to this notion of labor hoarding. So, it's a term that people want to throw around. Does it make sense for a company to say, "I want to warehouse labor because I know after this slowdown or after the recession, I'm going to need to source that labor. I'm going to have a hard time finding it. It has been so challenging to fill the slots I want to fill. If I see someone that kind of fits the skillset that I need, then I'm just going to warehouse that person." Fine. But if in fact, then you wind up seeing a slowdown, if profit margins do contract and then you've got to start to shed labor, not only are you going to shed the labor you might normally shed during a slowdown, you've got all these folks that you warehoused as well. And this potentially could result in more of a slowdown or more of a recession than what people are expecting.
Rob Almeida: It seems to me too that obviously you had a lot of people leave the workforce because of COVID. They got ill or they just said, "Look, life's too short. I don't want to do this anymore." And then to your point on labor hoarding, but also there's a lot of evidence of increasing capital investment. So, whether it's to reduce greenhouse gas emissions or shorten supply chains, build electric vehicle factories and semiconductor factories, is productivity there more difficult to measure perhaps? I'm just trying to come back to the purpose of putting capital to work when the return is zero.
Erik Weisman: So, I don't think we're going to see the effects of that productivity probably until 2024, 2025. To your point, we have two very interesting dynamics that seemingly are ahead of us. One is the implementation of this new industrial policy that the United States is implementing. So, the Inflation Reduction Act, which actually won't reduce inflation. It's actually inflationary, but we're going to ...
Rob Almeida: Inflation Accretive Act.
Erik Weisman: Exactly. I like that. I like the sound of that better. So, we're going to spend money on infrastructure. We're going to spend money on green energy. We need to prop up dirty energy for the transition. We're going to be spending a lot more money on defense. All of that is going to be, again, 2024, 2025. The defense probably won't help in terms of productivity, but the infrastructure will, the chips will, the green technology will. And as a byproduct, you also have this reshoring and friend-shoring. So, to the extent that some economic activity that we had farmed out winds up coming back home, that could wind up being synergistic. And you wind up getting productivity benefits from that, which again would be fabulous because productivity heals all wounds. Productivity allows you to pay the laborer, the capitalist and the government.
Rob Almeida: Everybody wins.
Erik Weisman: And everybody's happy.
Rob Almeida: So, let's transition. So, given that, and perhaps the central bank needs to do more or just need to wait, how does that map into your view on the shape of the yield curve, specifically your portfolios? And we don't have to get into too details, but in general, how do you think about managing duration? How do you think about expectations for capital returns in the longer end of the fixed income markets?
Erik Weisman: So, if you think a recession is somewhere around the corner, I mean you want to be overweight in duration, you want to be positioned for yields to go lower. I would have thought they would be lower by now. I would've thought we would've seen more imminent signs of recession or we'd actually be in recession by now. If you look at the shape of the curve, the curve is incredibly flat and inverted. You would expect that you would wind up seeing the curve steepen. That's what tends to happen prior to the recession. You flatten, flatten, flatten, flatten, then it begins to steepen. And that's usually a signal that the recession is nigh. And we keep seeing flattening. So, the Fed told us, "We want to raise rates to 5%." And the market said, "No way you're raising rates to 5%." And we got to 5%, now the Fed's saying, "No, we need to raise rates to 550." And the market is sort of saying, "Well, maybe yes, maybe no." And now the market's pricing that in, curves are going to continue to flatten until it's seemingly clear that the Fed is done.
And I think, again, it's going to be awfully hard for rates to rally. Certainly, it can't rally in the front end, but even further out the curve, it will be hard for rates to rally as long as the Fed is tightening more than we expected. Inflation is not getting back in the box as quickly as anticipated and labor markets remain relatively strong. You need some of that to go the other way. Yeah. Labor markets need to weaken, inflation needs to fall more quickly and the Fed needs to signal that it's done. And then when they do, if they truly signal, "We're done, we're not pausing, we're not skipping, we're not waiting." And the market says, "Aha, Fed's done. Next move is a cut." That's when I think you wind up seeing the belly of the curve that rallies and the curve steepen. But again, I would've expected we would've seen all of that to some degree by now. So, we keep pushing it out, as I've said.
Rob Almeida: So, from a, I don't know, maybe existential is not the right word, but we throw around terms like paradigm shift, regime change. The last, I guess ever since Greenspan, you've had a multi-decade era where investors were conditioned that they had a implicit Fed put. Given what happened in 2022, like you said earlier, inflation wasn't transitory, a lot of egg on central bankers' faces. Do you think perhaps now there's a paradigm shift and rates will be at a more natural level? Or do you think we'll go back? Because the question I get a lot from clients is, "Well, at the first sign of weakness, they're going to cut aggressively and we're back to where we were." And I guess my pushback is, well, given the strength of the labor market, given the strength of capital spending, maybe they can't do it.
Erik Weisman: So, I think there are two elements to this. One is, do I think rates are going to live in a higher envelope when we get to the other side of the expected slowdown recession? I think the answer is yes, and we can talk about that. We have talked about it. And the other is, do we think the Fed put still exists? So, there are two types of Fed puts. One is to do regulatory. So, we used that regulatory Fed put in the midst of that mini banking crisis. So, the Fed pulled another facility out of its hat, and it seems to have worked spectacularly well so far. We're only a few months removed from that moment.
The other is a policy rate, interest rate put, and that we just aren't going to know until and unless we wind up seeing more evidence that growth is slowing and perhaps winds up being recessionary, jobs are being shed and inflation gets stuck. Because that's when you're going to get a sense of Powell and other central bankers' intestinal fortitude. That's Volcker. That's Volcker saying, "I see the recession, it's happening. It's ugly. I'm sorry, but we have to continue to do it because that's the only way we can get inflation back in the box."
If the essential banks are lucky, we may see all of this happen at the same time. Growth slows, inflation slows enough central bankers can go on hold and eventually can cut and it will be the right thing to do. So, we're not going to know necessarily about that Fed put unless we're in the position where labor markets are weakening, growth is weakening, but inflation gets stuck because then you have to ask yourself, which is the policy mistake of least regret? Do you want to hold rates too high and cause more of a recession than you would like? Or do you want to capitulate and inflation gets stuck at too high of a level? Choose.
Rob Almeida: Right. Yeah. Sophie's choice there. So, before I let you go, you and I did an event together recently. We talked about AI. I had Brad Mak in here, manager of our large cap growth portfolio, and we talked about the implications of AI and through his eyes and through the tech team’s eyes and security selection, et cetera. So, from your vantage point, and I liked the way you framed it, if you could do so here again, about the technological advancements over the last 150 years. And maybe just share that with the audience and how you are thinking about it from an economist standpoint.
Erik Weisman: So again, historically, you look at technological advancements and how long did it actually take such that you could see it in productivity numbers. If you go back into the 19th century, we're not really measuring this stuff all that well, but it took a long time. So, some of those technological advancements that you might have seen post-Civil War, you don't really wind up seeing it in the numbers for a couple more decades. The technological advancements in the early part of the 20th century, you see it in the 1920s after a gap of 10, 15, 20 years. Same sort of thing happened with all of the digitalization and computers in the 1960s and 70s and 80s. And everybody's looking around saying, "Well, that's all fine and good, how come GDP has been relatively weak?" And then you do see it in the 1990s and Greenspan let the economy run, which at the time was a good decision and then in hindsight, maybe wasn't the greatest decision.
This all will likely happen in fast motion to some degree, but I still think it's going to take time. So, for those who are looking for productivity in the numbers in the next 12 months, I think you're unlikely to see it. And again, history would sort of argue that only the leaders — and the lucky leaders — are likely to get this right in the short to medium term. There are going to be far more laggards than there will be leaders, and some of the leaders will get it wrong. So, you kind of need to have both working in your favor. You need to be a leader who's willing to go out and break things and hope that you can put them back together in a more productive way. And then you have to be right.
So, some segment are going to go out and break things and they're going to die. Others will go out and break things and they'll figure it out. And everybody else is going to wait and see. And many of those laggards then will die because they waited too long. And it's a process. So, you wouldn't expect to see a whole heck of a lot in the next 12 or maybe even 24 months in terms of GDP accounting. But the market will suss it out I think, much, much more quickly, which is why you could see this very significant disconnect, and you're already seeing it between those who are producing the AI, those who are consuming the AI in terms of equity valuations and GDP.
Rob Almeida: Yeah. There seems to be some conflation happening in the marketplace between the science, the use case for it and the impact on the P&L, or the impact to whether you're selling the science as a future revenue stream or you’re utilizing the science to manage costs and be more productive. And like you said, these things take time, and this will probably happen a lot faster than those other episodes, but the market seems to be jumping ahead and assuming, okay, here's a vast array of companies that it's going to have commercial success and are going to be revenue creative. And like you've seen many times before innovators get innovated away. And so, we don’t know really who’s going to have that commercial application. Then on the other side, adoption curves take time and this adoption curve will be faster, but how to use it in the right way. And I think there’s a lot of pulling forward of assumptions, seems to me.
Erik Weisman: I’m sure it will unfold in a way that baffles many of us.
Rob Almeida: Right. Here’s what we’ve covered. So, recession isn't here yet, but the indicators and signals that you care about, that hasn't changed. They're still signaling that. These things take time. And look, we know the market is an impatient beast. Perhaps it's exhibiting the same type of impatience here in that this is coming. I've shared with you, I track bankruptcies and we're averaging a bankruptcy in the United States every day, day and a half. So at least from my vantage point, I'm starting to see it in select retailers and their PNLs, companies that sell non-discretionary goods, you're seeing a bit of stress. I think you're seeing it stress, particularly in private companies or smaller companies, and that's a big part of GDP. 70, 80% of GDP is small enterprises, and they are disproportionately leveraged to higher labor costs, higher interest expense, and I think these things take time.
Erik Weisman: I agree wholeheartedly.
Rob Almeida: Erik, thank you as always.
Erik Weisman: Thank you.
Rob Almeida: Thank you for listening to this edition of Strategist Corner Podcast with my guest, MFS Chief Economist, Erik Weisman. Please check out future Strategist Corner Podcasts on mfs.com or wherever you get your podcasts.
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