The Deflationary SpiralAll credit booms brought about by Central Bank-induced artificially low interest rates and loose lending standards end in busts. In the recessionary phase that follows the boom, credit becomes much harder to attain and many over-leveraged businesses end up going bankrupt. The recessionary phase reveals the malinvestments and unsound business decisions that were made during the economic boom. Businesses & Consumers deleverage their balance sheets either through paying down debt or through bankruptcy. As loan demand falls & credit conditions tighten, debt issuance falls, which reduces the supply of money into the economy because the vast majority of currency that enters the economy is loaned into existence. When credit growths slows and begins contracting alongside a falling money supply, inventory piles up and profits & margins fall while consumer spending falls. Businesses are then forced to sell at discounted rates to liquidate inventory in anticipation of weak future demand, which further reduces profits & margins and leads to increased unemployment and weaker levels of consumption. The “Deflationary Spiral” subsides and an economic recovery can take place once balance sheets are back to healthy levels which can support debt accumulation, capital investment recovers, and once large amounts of the “bad” debts taken on during the economic boom have been deleveraged.
US M2 Money Supply is currently down -4.2% YoY using March 2023 data, the largest monetary contraction in the USA since the Great Depression. Using data going back to 1870, every time the money supply contracted by over 1% YoY the stock market had a large correction and the economy fell into a severe & lengthy contraction with unemployment reaching at least 7%. A banking panic always accompanied those contractions as well. Commercial bank deposits are currently down around -5% YoY, the most since the Great Depression. Total commercial bank deposits didn’t even contract during the early 1990s Savings & Loan Crisis. With money supply shrinking and the majority of banks unable to pay competitive rates on deposits, deposits will continue falling and more bank failures will occur. The large amounts of unrealized losses on bank balance sheets represent another impediment to loan growth and banks have continued to raise reserves for multiple quarters in response to rising default rates.
Fed research from the Fed Bank of Saint Louis show bank lending conditions (measured by percentage of banks tightening lending conditions) are comparable to early 2008 & late 2000. Bank lending conditions are a leading indicator for unemployment. The unemployment rate currently is still below 4%, but with the Conference Board’s Leading Economic Indicators index currently at -7.2% and the bond yield curve still inverted, many reliable economic datapoints show that the economy is closer to the beginning of this business cycle downturn and debt deleveraging than the end. Yield curve inversions & Conference Board LEI’s have been some of the best leading indicators for a recession since the 1970s. Since 1968, any Conference Board LEI contraction of more than -2% YoY has never yielded a false positive in regards to a coming recession. The Credit Managers’ Index newly released data for April showed that the index for rejection of new credit applications (within the service sector) was 45.9, its lowest level since March 2009.
The US Consumer is beginning to run dry on savings. The majority of Americans are living paycheck to paycheck and consumer credit growth (which had been expanding rapidly in 2022) has slowed markedly. Total consumer credit growth has fallen about 50% YoY (using the 3 month average of data from December - February). After falling below 3.2% in the summer of 2022, the US savings rate is still low by historic standards, currently 5.1%. Announced job cuts for the month of March were 89.7K, higher than the first 3 months of the 2008 recession. US large corporate bankruptcy filings (Bankruptcies of companies with over $50M in liabilities) from Jan-April totaled 70, seven more than during the same length of time in 2008. Student loan debt payments are set to resume again this summer, which will further reduce consumer spending. US Consumer sentiment levels measured by University of Michigan hit the lowest levels ever (going back to 1952) in the summer of 2022, and they have been fluctuating around 2H 2008 & 1H 2009 levels ever since. Delinquency rates on things like automobiles, credit cards, and commercial real estate loans are soaring. Cox Automotive found 1.89% of auto loans in January were "severely delinquent" and at least 60 days behind payment, the highest rate since the data series began in 2006. In March, the percentage of subprime auto borrowers who were at least 60 days late on their bills was 5.3%, up from a seven-year low of 2.58% in May 2021 and higher than in 2009, the peak of the financial crisis, according to data from Fitch Ratings.
Retail sales are an economic metric that track consumer demand for finished goods. US real retail sales down -2.1% and EU real retail sales are -9.9%. German real retail sales for the month of march just came in at -15.8% YoY! According to Bloomberg, Global PC shipments are down close to 30% YoY & Apple computer shipments are down about 40% YoY. In the past 50 years, US Gross fixed capital formation has only gone negative in the US before and during recessions. It is now negative and there has never been a false positive. Data from the Mortgage bankers association showed a -39% YoY decline in Mortgage purchase applications, a decline to its lowest levels in over 26 years. US Building Permits are down -24% YoY. Housing Starts YoY are down -17% YoY. Existing Home Sales are down -22%. Every national housing downturn in the past 45 years has taken at least 4 years from peak to trough prices, indicating that the current housing downturn is likely to continue for at least 2-3 years.
Every FED Regional bank report on manufacturing (using a 3 month average of the data) is in a contraction. The April Philadelphia FED Manufacturing index came in at -31.3. Since 1969, Every reading under -30 was either in a recession or a few months away from one. April Richmond FED Service Sector Index registered a -23, the same number as in Nov 2008 & Feb 2009 & worse than Jan 2009 which was -20 (August and September 2008 were -10 for reference). US manufacturing production is down -.5% YoY. March 2023 ISM PMI data was also very insightful. USA ISM Manufacturing PMI (March) was 46.3, its lowest level since June 2009 (excl. H1 2020). For reference, in the 08 recession, it wasn’t until October 2008 that the ISM manufacturing PMI fell under 46.3, over 9 months into that recession. USA ISM Manufacturing New Orders (March) was 44.3, its lowest level since March 2009 (excl. January 2023 & H1 2020), USA ISM Non-Manufacturing PMI (March) came in at 51.2, its lowest level since Jan. 2010 (excl. H1 2020).
The US Stock market is trading at one of the highest Shiller PE ratios & stock market capitalization to GDP ratios in history. Present day stock market valuations are rivaled only by the Roaring 20s Bubble (1929), The Nifty-Fifty Bubble (late 1960s/early 1970s) & the 1999/2000 Dot-com Bubble. All 3 of those examples were followed by the most negative 10 year real returns in USA stock market history going back to 1913. Over 40% of businesses in the Russell2000 are unprofitable and over 1/5 of the S&P500 are zombie companies. Clearly, the stock markets as of April 2023 are still in bubble levels of overvaluation.
Looking at the data in aggregate, I believe that a recession is currently occurring. Assuming earnings fall by about 30% peak to trough, using a conservative average from the past 4 US recessions, I assume S&P annualized earnings will fall to around 155. Using a conservative valuation multiple of 14, that gives a target price of about 2,200 for the S&P500 that is likely to be hit in Q4 2023 or 2024.
Thank you for reading,
Alexander Charles Lambert
