Juggling Dynamite

The US yield curve’s last 17 months of inversion has been the second longest in history (2-10 curve inversion lengths shown below since 1941 courtesy of The Daily Shot).

Ditto for Canada, where the 2s-10s curve has also been inverted since July 2022.

Only four other times in history have seen this degree of inversion, and except for the summer of 1962, every one preceded a recession. Moreover, these incidents were followed by worse-than-average equity and corporate debt bear markets as government bond prices rose.

See, Canada is in economic decay. Prepare for BoC rate cuts and big returns in this asset class. Here’s a taste:

But when the negative gap between longer-term bond yields and rates at the front end of the GoC curve was as steep as it is now, the Canadian economy entered a recession 100% of the time.

Why are the Canadian banks tightening their credit guidelines and boosting their loan loss provisioning of late? Because they are being forward-looking and see things unfolding just as I do.

Economic decay is already underway. Real GDP growth in Canada has slowed markedly on a four-quarter trailing trend basis from a hot +4% pace a year ago to a chilly +0.5% as of the third quarter, as fiscal stimulus lags fade away and the bite from the radical tightening in monetary policy lingers on. This is a stall-speed economy and is either in recession or rapidly approaching one. When you adjust for the immigration-fueled +2.7% population boom, what this means is that the economy, in real per-capita terms, has contracted -2.2% over the past four quarters. You can only camouflage the dismal economic reality via unprecedented inbound migration flows for so long.

A worthwhile overview of current conditions and implications for asset prices and unemployment in this presentation…

In his Dec. 5, 2023, webcast, DoubleLine CEO and Chief Investment Officer Jeffrey Gundlach (0:06) tours a global environment undergoing a sweeping breakdown of norms that for decades conditioned the behavior of different assets, financing of the U.S. government and performance of the U.S. economy. Here is a direct video link.

Mr. Gundlach begins with the dilemma of the U.S. debt cycle (1:07), “something that is barreling right at us.” He presents a series of charts on federal expense (3:25) interest on U.S. Treasury debt outstanding and adjusting Congressional Budget Office deficit projections for the change in the federal deficit following previous recessions.

By 2028, the deficit could swell to between $3.5 trillion and $4.8 trillion (7:08), equal to 20% of gross domestic product. Mr. Gundlach turns to the question of whether a recession is coming (7:58). This discussion begins with the Treasury yield curve, as measured by yields on the 10-year and two-year Treasury. True to the form of its behavior leading into past recessions, the curve inverted for an extended period and has been de-inverting from a maximum inversion this cycle of negative 108 basis points. By this metric, he suggests that, if the Fed stands pat on rates while the 10-year continues to rally, the completion of the curve’s de-inversion, signaling imminent recession, could occur in “2Q or so of next year.”

Another metric (13:10), the backup of the U-3 unemployment rate, “looks remarkably like the front edge of a recession.”

With respect to markets, Mr. Gundlach disagrees with observers who see record asset levels in money market funds as bullish for risk assets such as stocks (17:47). Moving from Treasury bills into stocks, he says, would be a “monumental change in risk appetite”; rather, he sees the size of assets in money market funds as “bullish for Treasury bonds and other high-quality bonds.”

Our September 30, 2021, client letter “Shifting Foundations” highlighted the default of Chinese property developer Evergrande as a turning point in the real estate-centric China growth story with broad implications for the global economy:

China’s property sector has been the largest driver of its economic growth over the past decade and a significant driver of global growth. Concerned about overbuilding, speculation and lofty debt levels, Beijing introduced rules to limit the amount that developers can borrow. This has triggered insolvency in the sector and one of China’s largest property developers defaulted on bond payments to foreign investors this month. The story has broader implications for the global economy, commodities, and especially Canada.

Since 2019, Chinese property shares have fallen about 65% and counting, this month taking out the 2020 crash low to revisit the 2008 financial crisis bottom.

Perma-bullish Wall Street and late-to-act credit rating agencies have only recently been downgrading China’s economic outlook, as discussed in the segment below.

Shehzad Qazi of China Beige Book says the Chinese government’s priority is creating stability, not growth. Here is a direct video link.

After Japan’s legendary real estate bubble burst in 1989, property prices plunged for several years and have not recovered peak prices in the 34 years since. During the mean-reverting process, banks and other financial intermediaries took years to write down bad loans advanced during the bubble.

In related news, see: Housing accounts for an unhealthy 40% of Canada’s GDP.