Investor Essentials Daily

Here’s how a recession could cure this economy

October 30, 2023

Bank of America (BAC) strategist Michael Hartnett has his eyes on 10-year yields.

In his view, as long as 10-year bond yields stay below 5%, the market can more or less stay put.

This year, 10-year yields started out around 3.8%, which was already about as high as they’d been since the wake of the Great Recession.

As the Fed kept raising interest rates, the 10-year yield rose to a 16-year high of 4.8%. It hasn’t crossed 5% yet, although it’s not far off.

Until it crosses that would-be historic 5% threshold, he doesn’t see much of a reason for the S&P 500 to sell off in a meaningful way.

And while that sounds good on the surface, it’s not great if we want to put the current market environment behind us.

Frankly, we need a reset of some sort and the market stalling out won’t provide that. Today, we’ll talk about why a “soft landing” isn’t as promising as it might sound, and we’ll explain why Hartnett agrees with us that a recession might be the best path forward.

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The narrative the market has been talking about for a while has been the “soft landing” story.

The story tells of a controlled and moderate slowdown where the Fed slows the economy without pushing us into a recession.

This scenario would be great for investors in the short-term. Stocks wouldn’t drop as much.

However, a soft landing is unlikely to ever be the end of the story. You see, if the economy never shrinks, then the Fed is never going to lower rates. Remember, interest rates effectively act as a tax on the economy. Their primary purpose is to temper economic activity.

Fed Chair Jerome Powell has been clear. He is prepared to raise rates and keep them high as long as it takes to completely wipe out inflation.

And Bank of America’s Hartnett agrees with the strategy. He views a recession as a necessary “reset” for the economy that will allow the Fed to safely cut interest rates. That, in turn, will help power the next bull market.

A more aggressive rate adjustment could facilitate a genuine economic reset, positioning us for the necessary growth in the future.

This wouldn’t be the first time this economic cycle played out.

In 1947, to address soaring inflation, the central bank began hiking up interest rates.

This period’s inflation was primarily spurred by the economic surge following World War II. Returning soldiers had significant savings, and the national unemployment stood below 2%.

As the manufacturing sector transitioned back to its regular operations, the demand for products surged. However, supply couldn’t keep pace, leading to heightened inflation.

Thus, the Fed took it upon themselves to curb inflation. It hiked interest rates. It increased reserve requirements for banks. And it even sold a bunch of its Treasury bonds.

These measures hurt the economy just like today. However, the impact of the measures didn’t fully manifest until 1949 when a recession occurred.

During this recession, the Dow Jones Index fell approximately 12%. However, there is a silver lining. From the lows of the recession in June 1949 to the end of 1950, the index rose 41%.

When we suggest that a recession might be the most suitable remedy for the economy, we’re drawing from historical precedent. The current scenario bears striking similarities to conditions we observed seventy four years ago.

We’ve experienced consumers flush with cash because of a lack of spending from the pandemic. We’ve also seen high inflation, high-interest rates, and other Fed measures to tighten credit.

Ultimately, if history is any guide, experiencing a recession might not be as damaging as one might initially think.

For us, the central issue isn’t just whether interest rates and bond yields surpass 5%. We’re observing numerous historical indicators suggesting a looming recession and a following natural reset.

While this may lead to turbulent periods in the short run, it’s likely to benefit the market over the long haul.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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