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Gary Shilling: Recession Probably Shaping Up

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In January, Gary Shilling urged caution on stocks. By May, perceiving a high-risk environment, the economist and portfolio manager was holding the most cash ever. By summer, he was anticipating stock selloffs. Now Shilling is short on the aggregate stock market. Markets can lead to recession, he says, noting that the early signs of one have arrived.

Indeed, a recession is “probably” shaping up, he tells ThinkAdvisor in a wide-ranging interview.

The well known bubble spotter, 81, who accurately forecast the 1960 and 1991 recessions, and the end of a lengthy span of acute 1970s inflation, isn’t a total bear, of course: He’s bullish on the dollar and bonds, enthusiasm for the latter rooted in what he described 37 years ago as “the bond rally of a lifetime.”

Against a background of the long bull market’s sharp plunge from its late-September high, interest rate hikes and disappointing quarterly earnings reports, Shilling weighs in on all of the above, as well as emerging markets, protectionism, deflation, oil prices and how the outcome of midterm elections could affect the stock market.

President of A. Gary Shilling & Co., an economic consulting and investment advisory, the former physicist was an informal economic advisor to George H.W. Bush. He began at the Federal Reserve Bank of San Francisco and Bank of America, and was soon appointed Merrill Lynch’s first chief economist.

In the interview, the perennial critic of the Federal Reserve, surprisingly, offered praise for a change in M.O. that new Fed chairman, Jerome Powell, has made.

ThinkAdvisor held a phone interview with the Short Hills, New Jersey-based Shilling on Oct. 23. A conversation with the longtime apiarist would be incomplete without touching on his unusual hobby. The news there, he says, is that winter weather demands special provisions and protection for the 100 bee hives he keeps.

Here are excerpts:

THINKADVISOR: You’re famous for spotting market bubbles. See any now?

GARY SHILLING: I don’t see anything sitting there just itching to burst. But we’ve had an awful lot of bear markets and recessions that didn’t have bubbles — most of them, in fact. If there’s a bubble, the most likely candidate is emerging markets. Whether that’s enough to sink the global ship is questionable.

Is a recession looming?

If there’s a recession shaping up, and there probably is, it’s just a question of how soon it’s going to arrive. It will probably come about for the more conventional reasons than any bubble. Bear markets and recessions are mostly the result of the Fed tightening when the economy is exuberant.

Why is a recession shaping up?

You’re already starting to see the normal signs: housing looks like it’s topped out. Housing is usually the first major leading indicator of a recession because it’s so interest-rate sensitive — and housing never had a huge recovery [after the financial crisis]. Housing will continue to be under pressure. Another leading indicator is the inverted yield curve [of interest rates]. It isn’t up there yet, but the way the Fed is going, it could be. And you’ve got the protectionist actions and what they do to create uncertainty and to slow global growth.

Do you think the Fed will cause a recession with its interest-rate hikes this year and into 2019?

It could be some time before they finally do the deed and precipitate a recession, but stock markets can lead a recession considerably.

Is the bull market coming to an end, then?

It wouldn’t surprise me. Markets die from either of two causes: The Fed jacks up interest rates to the point where they end up killing the economy and precipitate a recession, which is preceded by a selloff in stocks. The other cause is a financial shock, which is what happened with the dot-com selloff and then, of course, with the subprime mortgage collapse.

What could be a shock now?

Nothing looks like it’s begging for a collapse. But there are candidates: Emerging markets is the most likely. With the dollar strengthening, they’re obviously in trouble servicing their debts.

How are you positioned in the stock market?

I’m bullish on the dollar, long the dollar. I’m bullish on bonds. I like long Treasuries. I’m bearish on stocks. I think stocks are going down. We have very, very tiny positions in U.S. equities. We’re short the aggregate stock market. We’re short on emerging markets. I think they’re in big trouble.

Back in May, you were holding the most cash ever. Why?

We thought things were very uncertain and that it was a high-risk environment. Since then, it’s [even] more on the downside; so we’ve become more involved in assumptions that we’re going to see selloffs in stocks. Right now, we don’t have the biggest cash position because we’re short things like emerging markets and the S&P.

What impact on the market do you think the midterm elections will have?

The betting is that the Democrats will gain control of the House. If so, probably not much would happen in terms of the markets because that’s already anticipated. But if the Republicans do better than most people expect — and I think they will — that could be a stabilizing effect for equities. Even if there’s a recession unfolding as we speak, that wouldn’t be apparent until after [the midterms].

How much are corporate earnings responsible for the market volatility we’re seeing?

There’s been a big run in earnings. A lot of that was because of the tax cuts. But the strong dollar creates losses for U.S. multinationals with foreign earnings when those translate back into dollars. That’s a factor — though earnings tend to be more of a coincidental indicator; they pretty much ride with the economy.

What do the recent earnings indicate?

A slowing economy — slowing momentum — is what you get toward economic peaks. Earnings that were growing start to slow before they actually decline. Also, record job openings and low unemployment are very reminiscent of a peak in the economy.

What will be the impact of President Trump’s trade war with China?

[Trade wars] tend to slow things down in the economy too because of the uncertainty and reorientation of supply relationships. I think the U.S. is going to win against China because we’re the buyer, and they’re the seller. With plenty of goods and services in the world, it’s the buyer who’s got the upper hand — and Americans buy all those consumer goods. But the transition is the biggest [concern] on a short-term basis.

Please elaborate about that transition.

It’s difficult because you’ve got to shift things around, and conventional business relationships get shaken up. That tends to slow down economic activity and promote deflation. The transition is an inefficiency and a deflationary force.

What’s your forecast for oil prices, which have been rising?

There’s plenty of supply and peaking demand. So I think that long-term, the outlook for oil prices is probably not so hot. There’s going to be peak demand. That’s ironic because earlier we probably had a peak in supply. We’ve gone from concern about peak supply in oil to a peak demand — an amazing change.

What are contributing factors to the peak demand?

Conservation measures and alternatives, like wind and solar power. Natural gas has become a big competitor. If electric vehicles really take off, it’s going to make a huge dent in the demand for gasoline and, hence, oil. Half the oil in this country goes into transportation, and half of that is in personal transportation.

Why are you bullish on bonds at a time when many other experts are bearish on them?

Right now, you’ve got a tradeoff between spillover in bonds from the Fed raising rates on one side and deflationary forces on the other. But the spillover from the Fed’s actions is relatively muted. The portfolios we manage have moderate bond positions, which are doing very well to date because bonds are a safe haven. When stocks are falling out of bed, people look at safe havens, and those tend to be bonds and the dollar. In the long run, what affects bonds is inflation.

So the U.S. isn’t in an inflationary environment?

We’re in a very deflationary world. Protectionism is extremely deflationary. It disrupts economies and slows down growth. But we’re still in a very much globalized world with cheap production on a global basis. So unless we go completely protectionist, we’re going to continue to see downward pressure on prices.

Are there many other deflationary forces in the world right now?

Yes, a lot, especially in services. And services are where it really matters: About two-thirds of consumer spending is on services, only one-third on goods. Look at financial services. It’s a competitive race to the bottom!

You’ve been a sharp critic of the Federal Reserve, which, in a July 2017 interview with me, you called “completely clueless.” How do you assess the Fed now that it’s hiking rates?

The Fed is doing what they think they have to do. They don’t want to kill the economy, but they worry about overheating. They also want to have rates high enough so they can cut them when the next recession rolls around.

What do you think of Chair Jerome Powell’s job performance thus far?

The Fed isn’t yet back to a neutral rate; and he’s, sort of, saying, “We don’t know where that is.” Basically, he’s saying that [the Fed] is forgetting about “forward guidance.” I think that’s one of the most encouraging developments.

What’s “forward guidance,” and why is dispensing with it a positive?

In the aftermath of the financial crisis, the idea of transparency [became a focus]. And the Fed — these guys are mere mortals — got bitten by the transparency bug as well. So they came up with “forward guidance” — the idea of telling the world what they were going to do in the hope that it would create stability.

What was the result of that policy?

It was a huge mistake because the Fed has been a very poor forecaster. Their data-driven decisions have been pretty lousy in forecasting the economy. They’ve been way overestimating growth, raising interest rates and inflation. From our standpoint, forward guidance hasn’t created stability. So forgetting about it is a big improvement.

Let’s now turn to your hobby for nearly 30 years: beekeeping. It’s “an ever-changing mystery to be solved … by analytic thinking” and a bit of luck, you write. How are you preparing your 100 hives for the cold weather?

We’re tucking them in for the winter. Bees make honey to get through the winter, but sometimes they run out; so we put in sugar syrup for them to make sure they get enough to eat. We put mouse guards on the entrances of the hives because mice love to get into beehives when it’s cold. It’s nice and warm in there. They eat the honey and raise hell.

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