The first scenario he calls the “Roaring Twenties.” Here, “our basic premise is that a chronic shortage of labor is forcing companies to use technological innovations to boost their productivity growth, which started to improve last year, according to the government’s quarterly data,” Yardeni wrote in a client email on January 21. “As a result, inflation remains subdued in this scenario, while real GDP growth, real wage growth, and profit margins all get boosted.” He says there’s a 60% probability of this scenario coming to pass.
There’s a 20% chance of the second scenario. He dubs this one “the 1970s,” since several economists have compared that period to the last couple of years when inflation returned. Even though price increases slowed in 2023, he writes, “there is still a risk of a second inflationary energy shock as occurred during the 1970s.” This one, however, would be tied to geopolitical problems, including “Russia’s invasion of Ukraine in early 2022. If the conflicts in the Middle East continue to spin out of control, oil prices could soar again.”
In the ’70s scenario, “the Fed is forced to raise interest rates … and cause a recession,” an outcome that was quite believable a year ago. Equities in this situation would likely perform dismally. However, inflation indeed began to wane early last year, and the advent of AI has re-energized the stock market. Most important, the economy accelerated in 2003’s second half.
In the January 21 email, Yardeni outlined a third scenario: a 1990s-style stock market bubble exacerbated by Fed policy (this, too, won a 20% chance of happening). In this worrisome case, the Fed grows “concerned that inflation is falling below 2.0% and responds by aggressively cutting interest rates, even though the economy continues to perform well.”
That could spur a “melt-up” in the stock market, a surge led by technology stocks. “The resulting valuation bubble bursts when the Fed is forced to raise interest rates, because asset inflation shows signs of precipitating another round of price inflation,” Yardeni concludes.
His stock market target is for the S&P 500 to finish this year at 5,400, so one can only imagine how far a melt-up might take equities.
Debt Catches Up
Voices of dissent say the central bank is likely to remain more hawkish than the prevailing view suggests, and view as unrealistic the notion that the Fed would cut rates four to six times in 2024. Macro strategist Jim Bianco, founder of the Chicago consulting firm named for him, raised eyebrows earlier this year when he told Bloomberg he thought the bond market could be dead wrong and that a surprisingly strong economy could send the 10-year Treasury bond yield back to near 5.50%.
The huge fourth quarter rally in bonds priced in five or six rate cuts later this year (it gave back some gains in January), and Bianco calls these assumptions “wildly optimistic.” In his view, investors should be thinking about rates headed higher later in the decade.
Like Bianco, Loomis Sayles’s vice chairman, Dan Fuss, says his team thinks the economy will remain resilient and avoid a recession. “I don’t know how we get a rate cut in March unless the economy really falls off or a war breaks out,” he says. And by a war, he’s referring to one that cuts off Saudi oil, not a continuation of the skirmishes proliferating across the Middle East.
Even if it’s “almost heresy” for a longtime bond fund manager to say it, Fuss concedes he favors stocks “slightly over bonds.” That’s because “corporate spreads” over Treasurys are “so low I don’t see them staying that low.”
High-yield bonds have been a favorite at Bondbloxx, a fixed-income exchange-traded fund firm, especially as the business cycle turned buoyant in the face of recession expectations last year. JoAnne Bianco, an investment strategist at Bondbloxx, says conditions continue to be strong for high-yield issuers; the firm doesn’t anticipate an increase in defaults this year.
One bond market participant who shares Dan Fuss’s and Jim Bianco’s skepticism about lower interest rates over the long term is Jeffrey Gundlach, CEO of DoubleLine Capital. But he’s also more negative about the economy in general. He says the leading economic indicators index has been misleading in the current cycle because it’s heavily weighted to manufacturing indexes, and these industries got very weak just as services industries like travel enjoyed booms, he said on a January webcast.
Unlike most institutional investors, Gundlach isn’t impressed with the strength of U.S. employment, which is already shrinking in many cyclical sectors. “The labor market is the last to go,” he said. “Once [unemployment] goes up, it can go up pretty dramatically.”
It’s the national debt situation that has Gundlach’s attention, as $17 trillion, or about 50% of the total, expires in the next 36 months. Many of those Treasurys were issued in the last five years with coupons of 1% or less.
Gundlach finds the economy weaker than many of his rivals do, but like Jim Bianco he anticipates a day of reckoning for the U.S. Treasury as it is forced to sell trillions in debt every year. He believes a recession is closer, too. In the next one, the market isn’t going to see a bond rally, he predicts. The Fed will want to keep interest rates lower to keep interest expense under control, as interest is currently 15% of the total federal budget.
“Rates could go down to 3%, but they won’t hold,” he told webcast attendees, adding that we might see rising rates and an inflationary reaction to the next recession.
“Medicare is projected to go bankrupt in eight years by their own trustees and Social Security in 10 years,” Gundlach says. “It’s our grandchildren’s problem or our children’s problem. It’s our problem.”