Gary Shilling: The Recession May Have Already Begun

A U.S. recession “may already be underway,” and the bond market rally that began in the early 1980s is still intact, says Gary Shilling, founder of the investment advisory firm A. Gary Shilling & Co.

In his latest Insight report released just before Friday’s stronger-than-expected jobs report, Shilling writes that the 10-year Treasury note yield will drop to 1% in a year and the 30-year Treasury bond will drop to 2% a year after the recession starts, delivering double-digit returns. In that case, the 10-year Treasury would gain close to 12%, and the 30-year Treasury bond 14%.

The 10-year Treasury note ended Friday trading with a 2.03% yield after slipping below 2% on July 2, and the 30-year Treasury bond finished with a 2.54% yield following a decline below 2.5% on July 3. The yields of both securities bounced back following the jobs report, which led many traders and analysts to question expectations of a Fed rate cut later this month.

“To the surprise of almost every other forecaster, Treasury note and bond yields have plummeted since last fall as their prices leap,” writes Shilling in his latest Insight analysis. “Low and declining inflation as well as heavy buying by foreign and domestic investors are important drivers. The recession we believe is already underway will further depress inflation and enhance Treasurys’ safe haven appeal.”

Moreover, writes Shilling, “The moderate recession we see could be deepened by a collapse in low quality nonfinancial corporate debt, troubled emerging economies or a full-blown trade war with China.”

Months ago, Shilling gave 66% odds of a recession this year. Now he cautions against believing that interest rate cuts by the Federal Reserve will save the day for stocks even though “equity investors seem to have complete faith in the Fed to keep the good times rolling.” 

“Given the lags with which monetary policy changes work their way through the economy, actions by the Fed now will have little effect for many months. If a recession is in the cards or, as we believe, is already underway monetary ease in coming months may influence the business  recovery record two to four months hence, but will have little effect on the economy in the meanwhile.”

Even after the Fed begins to ease monetary policy through rate cuts, the impact on the economy will be limited for several reasons, according to Shilling:

• The Fed has less than half the room to cut rates than the 500 basis points it typically has when addressing recessions. The federal funds rate is currently 2.25%-2.5%. As a result, the Fed “may slash rates sooner and in bigger increments,” writes Shilling, suggesting at least a 50 basis-point cut rather than the usual 25 basis points.
• Quantitative easing, which the Fed used during the Great Recession and could use again for the next recession, has limited impact on the economy. During the Great Recession it bid up stocks, rather than spending and investments, writes Shilling.
• Cyclical industries such as construction and manufacturing, which are the sectors most susceptible to credit easing policies, account for a much smaller part of the U.S. economy than they did historically — now just 13% of U.S. jobs compared with 25% in 1980.
• The U.S. consumer, who is the main driver of the U.S. economy, is already spending less due to a decline in personal spending and is more likely to save than borrow when rates decline because of current relatively high levels of household debt.

“In effect the Fed had little ammunition to fight a recession so federal efforts will shift to fiscal stimuli,” writes Shilling. “Infrastructure stimuli may be emphasized,” he writes, since both political parties seem to favor such spending.

Shilling recommends, as he has for at least several years, that investors own long-term Treasuries for capital appreciation and the U.S. dollar, and hold a heavy cash position. Among stocks, he favors consumer staples, utilities and health care sectors. Year to date, all three sectors sector have underperformed the S&P 500 as well as other stock sectors such as technology and industrial and consumer discretionary stocks.

Shilling admits that the recent behavior of the stock and bond markets imply “diametrically opposite forecasts. Equity investors seem to have complete faith in the Fed to keep the good times rolling … [while] investors in Treasuries appear to be forecasting a recession and lower inflation, if not deflation.”

He remains decidedly a bond market bull. “in the early 1980s when the yield on the 30-year Treasury was 14.6%, we stated that ‘we’re entering the bond rally of a lifetime.’ Since then, the decline in yields has made their total return five times greater than that of the S&P 500. We believe that the Treasury bond rally is continuing.”