- Multiple big banks (and plenty of pundits) anticipate a “soft landing” — meaning that the economy will settle down, so to speak, instead of crashing. But sooner or later, we’ll experience a recession.
- The question for investors is when to expect a recession. Much of Wall Street seems optimistic at the moment, but Christopher Zook of CAZ Investments is much more cautious. He argues that if we study economic history, we’ll see that the bond market suggests otherwise.
- What does the Silicon Valley bank collapse portend for the future? Why will we experience a new mortgage crisis within a few years? And why is the phenomenon of stagflation so stubborn?
Investors can’t control the ebb and flow of the market, but they can (carefully) ride the waves.
Christopher invokes Warren Buffett’s axiom that although “a rising tide floats all boats … only when the tide goes out do you discover who’s been swimming naked.”
Of course, some savvy investors capitalize on those low tides and win market share from those skinny dippers. But either way, a recession will happen — sooner or later.
With more than 30 years of investing experience — and a mandate to safeguard Texas state employees’ nest eggs as a State Pension Review Board member — Christopher chooses data-driven deliberation over gut-level decisions. As a firm, CAZ is a “big-time student of history,” and its leader has no problem eschewing the prevailing market feelings.
On an Allocator edition of Top Traders Unplugged, Christopher tells host Alan Dunne why he’s cautious about the opportunities in capital markets now — and why he has no problem swimming against the tide (fully outfitted, of course). Read on for a curated selection of insights from their conversation.
Should we expect a ‘soft landing’… or a swift slump?
The stock market is a “forward-looking animal,” says Christopher. “So it is anticipating what it hopes is going to be a pause and then an easing by the Federal Reserve and other central banks around the world, and that we’re going to be off to the races again. Inflation will come down; earnings will grow to the sky.”
But he is “not exactly a believer” in those high hopes.
Although he admits the market “could be right. This soft landing could be navigated by the Federal Reserve … maybe we really can get into a slow-growth environment again,” he thinks we have distinct signals to the contrary.
He looks to the “dichotomy between the stock market and its rally and the bond market, which is clearly telling us there’s a recession coming — and it’s going to be a doozy. So either the stock market is wrong or the bond market is wrong.”
History suggests the bond market is the one to watch. The inverted yield curve has a way of predicting recessions, which means the stock market “is likely a little bit overzealous and a little bit ahead of itself,” Christopher argues. “It’s likely to have a day of reckoning pretty soon.”
‘Pent-up’ post-pandemic power
Whenever the next recession comes, it has arguably been the most hotly anticipated recession ever, says Alan.
“We’ve had 500 basis points of Fed rate hikes and nothing has broken. We had a wobble — and challenges in the banking sector — which have been papered over or fixed, depending on your perspective.”
Alan asks Christopher whether he has been surprised by the resilience of the U.S. economy amid this current tightening cycle.
“It has been a little surprising and actually pretty impressive,” Christopher replies. “It shows the power of pent-up demand coming out of COVID.” He notes the “sticker shock” many of us know all too well, especially regarding hotel rates and other travel expenses.
He also points out how busy the travel sector has been despite those prices. He does think this dormant demand has shifted through other areas of the economy. One example is the used car market: Prices skyrocketed during the pandemic, but their rebound (coupled with higher interest rates) makes it difficult for consumers to buy pre-owned vehicles.
Is SVB the proverbial coal mine canary?
Compared to prior decades, the recent tightening cycle happened lightning fast — while “the Fed has slammed on the brakes and nothing has really happened yet” other than seemingly discrete incidents like the Silicon Valley Bank collapse. But consumer credit card rates in the U.S. average just over 21%, and “people have less disposable income” due to rising mortgage rates. “Enormous amounts of adjustable rate mortgages [are] not yet adjusted on residential mortgages,” he points out. “That is still going to happen, primarily between 2024 and 2027.”
We should expect substantial “readjustment to spending habits” during this window of time … which of course is the biggest component of GDP,” he adds — “as well as significant amounts of defaults in the real estate world, which is going to lead to immense pain in the regional banks.”
CAZ Investments’ stance is that Silicon Valley Bank was “the canary in the coal mine,” Christopher says.
Alan thinks plenty of households will go into the coming recession with “good balance sheets,” especially because “a lot of people locked in some favorable rates. But certainly, on the corporate side, they eventually will have to be refinanced. So you’re thinking the 2024 to ’27 period … for real estate in particular, that’s the time span where it’ll really bite. Is that right?”
“Very much so,” says Christopher. “[But] a lot of people don’t understand the ‘why’ behind that timeframe.”
Consumers may have ‘healthy balance sheets’ while living paycheck to paycheck
Christopher explains that between 2019 and 2021, we saw an “enormous surge of borrowing … all at extraordinarily low interest rates.” Not all, but most loans have a 20 or 30-year amortization period but a five-year bullet, meaning they have to be refinanced when they reach maturity after five years. That’s why he thinks the years between 2024 and 2027 will be troublesome, especially for consumers.
However, the impact on the consumer isn’t getting enough press right now, he adds. The majority of home loans made between 2019 and 2021 were adjustable-rate mortgages. So while the average consumer’s balance sheet may be much better “coming into this recession than we’ve ever seen … most people, especially in the United States, are living as close to paycheck to paycheck as they ever have been despite those healthier balance sheets.”
At first, those average Americans lived off of the stimulus; then they tapped their savings, which are rapidly dwindling; now, “they’re rapidly increasing their credit card debt because they don’t want to adjust their lifestyle,” Christopher adds. “But they’re going to have to. When rates get high enough for long enough … they’re going to have to tighten their belts.”
Of course, when consumers reduce their spending, the economy slows down. That “bodes for a very strong, significant recession, probably over the next 18 to 24 months, and maybe sooner.”
Stocks, bonds and stagflation
Alan circles back to Christopher’s mention of the disconnect between the bond market and the stock market, which is apparently “looking at something else,” he says. “Last year, 2022, [was] a tough year for both stocks and bonds and probably stagflation. That kind of concern was really the big driver of markets. That seems to have gone … but I get the sense you still think that’s a risk.”
Christopher says “stagflation is real — it’s here; it’s not coming.” He thinks our “stubbornly high inflation rate” is likely to continue “for a foreseeable period of time, particularly [with] a lot more onshoring of significant manufacturing …. [which will] create some real significant pressures on inflation.”
At the same time, our economy is “stagnant” even though unemployment hasn’t spiked, but that’s unlikely to be “a strong tailwind for the economy.” Job growth seems doubtful, too. Taken together, we have a recipe for stagflation.
Historically, stagflation is the “worst possible environment for stocks and bonds,” Christopher adds. “If we end up with an inverted yield curve for an extended period of time, which would be very unusual — but it’s possible, particularly if the Fed can manufacture this soft landing.”
If that happens, he thinks it will be tough for companies to raise prices to keep up with inflation, which will cause profit margins and earnings to decline.
But it’s also unlikely that bond investors will see significant returns. Over the next five years, they shouldn’t expect more than a 4% to 7% total return on their portfolios.
“That, of course, means that you’re likely to have a positive real rate of return after taxes … [and] a decline of your purchasing power,” he says.
‘Work your tail off’
Christopher’s arguments aren’t exactly rigorous — financial markets aren’t a science — but they reward precise moves, even if they’re not initially apparent. Data-driven decisions are undoubtedly the best way forward.
Stagflation, soft landings … none of them will influence the market enough to insulate anyone who isn’t hedging their bets before a much-delayed — but probably inevitable and protracted — recession. Consider yourself warned.
On an upbeat note, Alan asks Christopher to share advice for new entrants into the finance industry — or investors generally — before wrapping up the interview.
The most important thing, says Christopher, is to “read everything you can.”
Next, cultivate attention to detail and work ethic.
“If somebody focuses on the details and works their tail off; usually, good things are going to happen. It’s just hard to mess up,” he says. “But specifically, most of the people … [who] aren’t successful don’t have a plan [or] they don’t stick with their plan.”
He cites Stephen Covey’s wisdom in “The 7 Habits of Highly Effective People”: “Begin with the end in mind and then work your way backward to where you are today … how you’re going to build a path to get to that outcome,” Christopher paraphrases.
“Figure out a way to persevere through all the challenges one will encounter. Ultimately, just go make it happen because life’s too short to sit back and wait and let it happen to us.”
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.