Wharton’s Jeremy Siegel and David Rosenberg of Gluskin Sheff discuss the odds of an imminent U.S. recession.

Does the U.S. economy face an imminent recession? The recent mix of deteriorating economic indicators points to a slowdown, according to David Rosenberg, chief economist for Gluskin Sheff, a wealth management firm. The biggest problem in the latest GDP report is the fall in business spending, he said, adding that he believes a capital spending-led recession is looming. “I wouldn’t be surprised if in the next three to four quarters, we see a flat to negative print. This coming recession will not be defined by the magnitude or the peak-to-trough weakness in GDP as much as the duration.” It will also be marked by how difficult it will be for monetary and fiscal policy “to get us out.”

Rosenberg spoke on Wharton Business Radio’s Behind the Markets show on SirusXM with Wharton finance professor Jeremy Siegel and moderator Jeff Weniger, director of asset allocation at WisdomTree Investments. Before joining Gluskin Sheff, Rosenberg was chief North American economist at Bank of America-Merrill LynchThis conversation came before the Fed’s quarter-point interest rate cut on July 31 — the first in more than 10 years.

Rosenberg noted that capital spending is weakening due to “general global uncertainty, politically and economically” and cash flows that are being used to service debt in a coming “tsunami of corporate debt refinancing.” That is why the next recession will be stoked by “corporate balance sheets, not household balance sheets” as in 2008. He expects the Fed to cut rates “pretty aggressively over the next year. This economy is not out of the woods by a long shot.” Siegel agrees with Rosenberg that a slowdown is looming, but he does not think that a recession is imminent.

Below is an edited transcript of the conversation. (Listen to the podcast at the top of the page.)

Jeff Weniger: Please offer your views on the Fed, the latest GDP numbers and the economy in general.

David Rosenberg: I am actually quite happy that [Fed Chair Jerome] Powell seems to have signaled that the Fed is no longer data-dependent. I’ve never really liked that philosophy because if you are following the data you are destined to make a policy mistake, because the data are backward-looking. And, given the impact that monetary policy exerts on the real economy, those lags are long, variable and insidious. They can last anywhere from 12 to 36 months.

So you are just doomed to be making a mistake if you are following the data. Let traders and economists and pundits follow the data. The Fed should really be forecast-dependent. And it’s not about a point forecast; the Fed didn’t make a lot of fundamental changes to its published forecast. What it did verbally is tell you that the comfort zone or the band of certainty around their forecast has changed materially over the course of the past few quarters.

“My thesis all along has been that this will be a capital-spending led recession.” –David Rosenberg

That is really important, because if you go to a portfolio manager and you say, “This is my base case, but I’ve changed my probability of it happening from 80% odds to 40% odds” even without making a numerical change to your view, they are going to make some changes to how their portfolio is constructed.

The Fed has been consumed with the neutral fed funds rate. (The rate at which it neither stimulates nor slows output.) I was rather surprised that Powell  — he’s not an academic, he’s a credit markets guy — comes in guns blazing talking about how far the Fed is from neutral. It was on Oct. 3 last year, after the rate hike in September, when he said that we were a long way from neutral and we may have to go above neutral. And that is really when the Trump tweets started going wild, and then of course for the first time ever, the Fed tightened policy into a market maelstrom in December.

I’ve done a lot of work on the neutral funds rate. I remember when [Fed board governor Lael] Brainard said what is really important for monetary policy is the short-term neutral funds rate. I’ve done my own work on where observable or measurable inflation is in the U. S. Most of the scholarly research would say that the funds rate in real terms, that is at neutral equilibrium, is around 0.5%, 0.6%. I get the neutral funds rate closer to 1.5% than 2.5% (which many analysts agree with at the moment). It is hard to believe that just about seven or eight years ago the Fed’s estimate of neutral was 4.25%. People tend to forget that. And it got as low as 2.75%. Then Powell comes in, and it goes to 3%. I think that was a classic mistake. And now they are back to 2.5% and they are still too high.

So, when people are debating, “should the Fed do this, or should the Fed do that,” there are two things. They are operating policy based on their forecast, not on the lagging indicators or coincident indicators. And Powell said something very interesting in the second day of his Congressional testimony a couple of weeks ago; he acknowledged that the Fed overtightened. And, of course, that means they are probably going to have to take the neutral funds rate prediction down even more. I think they overtightened by 75 to 100 basis points. Just to get down to neutral that is where they have to be. That is probably what they are going to be doing — whether or not they get a recession. That is already priced into the futures curve. … I am certainly lining up more dovishly than hawkishly.

The current GDP number is pretty mixed. (U.S. GDP growth fell to an annual rate of 2.1%  in the second quarter from 3.1% in the first quarter. In 2018, the economy grew by 2.5%, rather than the 3% previously reported.) It was heavily influenced of course by the 70% of the GDP pie called the consumer, which was up at a 4.3% annual rate. We have to take that in the context of two quarters previously, each one barely more than 1%. But what has me a little concerned here is how that 4.3% growth in consumer spending — which seems like a lovely number — was really constructed, because we know that real after-tax income was only up at a 2.5% annual rate.

So this [increase in consumer spending] was really funded by a draw down in the personal savings rate. Of course, you could see that in the very strong numbers that we’ve gotten of late in terms of revolving and non-revolving consumer credit. But if we had held consumer spending to the rate of growth of organic income, that wouldn’t have been 4.3%, it would have been 2.5%. And real GDP would not have been 2.1%, it would have been 1.0%. And we would be talking about this stalled-speed economy.

So the tenor behind what happened on the consumer side leaves me relatively unimpressed. And then you take a look at some of the other components of the report. Real exports are down 5.2% in annual rate and, for the first time in three years, capital spending, business investment was -0.6%. Even with the dramatic downturn in mortgage rates, all the heavy lifting that the bond market did to get mortgage rates down, here we have residential investment and housing at negative at -1.5%. Housing in the GDP accounts has contracted now for six consecutive quarters. We haven’t seen something like that since 2008, 2009.

“I don’t see [a recession coming up]. I also think that the Fed has enough silver bullets.” –Jeremy Siegel

Weniger: Housing is decidedly weak in places like Manhattan, San Francisco. It is almost a follow-on to what you have seen in Sydney and Melbourne. Do you think that could end up being one of those next developments that acts as a black cloud over generalized sentiment?

Rosenberg: What concerns me is not the housing market. I think at some point we are going to level off in the next couple of quarters. And it’s not necessarily consumer spending, which I would refer to as a low quality 4.3% in consumer spending. It is the drawdown in the savings rate. The reality is that income was only up 2.5%, which isn’t terrible, but it shows you the extent to which consumption growth has outpaced real income growth. What catches my eye here is the decline in business spending. My thesis all along has been that this will be a capital spending-led recession. The trade tensions and tariffs are an added source of aggravation.

I always say after a Fed easing cycle, “Follow the bubble.” Then, of course, when you get the Fed tightening cycle, you find that the bubble tends to burst or you see the helium come out of it. The bubble this time is in corporate balance sheets, not household balance sheets. There is a whole host of reasons why capital spending is weakening. A lot of it comes down to the general global uncertainty, politically and economically. It is also a reality that for the first time in five years we are going to have a tsunami of corporate debt refinancing. We will find a lot of cash flows being diverted to debt service even under the slow industry environment and away from capital spending.

We have seen this in past business cycles. Lower capital spending will lead to declines in employment or certainly weaker employment conditions. We’ve seen that lately …  look at the Jolt survey. Professor Siegel is right, the jobless claims numbers were very low. Nobody wants to fire staff because we don’t have any talent left in the labor pool, so you want to hang on to your best talent. But the hiring rate is slowing down materially. Another thing that caught my eye in the latest ADP number is that small business employment has contracted now for each of the past two months. Small business employment is a great leading indicator for the labor market and the economy. That is starting to roll over.

Jeremy Siegel: David, where do you think the neutral real Fed funds rate is?

Rosenberg: The question becomes, what is the core inflation rate? So much of the CPI (consumer price index) and PCE (personal consumption expenditures) are imputed by the government statisticians. But if you look at inflation for goods and services, they can actually measure relatively precisely: Underlying inflation is closer to 1% than it is to 1.5% or 2%. That is why I say that the neutral nominal fed funds rate is probably close to 1.5% as opposed to the Fed’s published rate right now, which is 2.5%.

“The bubble this time around is in corporate balance sheets, not household balance sheets.” –David Rosenberg

Siegel: I’ve been saying for a long time that one of the big phenomena of the last 10 years is the collapse of real interest rates, both on the long run and the short run. I totally agree with you; the Fed has been way too slow with lowering the long-term neutral rate.

I have to give [retired PIMCO co-founder] Bill Gross credit. He talked about the real new neutral. He said it was zero. I think it was 2014 when he said … “We’re in a new world that has much lower interest rates.” Personally, I think it could be zero. Now you are redefining the inflation rate, so in a way we could both adjust that one way or the other. But given the published inflation rate I think the new neutral is zero, maybe even minus 0.5%.

When you look around the world, at the level of risk aversion and savings, the Fed’s rate is way too high. I think you are right. What happened was that Powell took the Fed funds level, which is way too high, and said, “Unemployment is so low, therefore we should be at that spot and maybe even a little above it.” That was the standard Phillips curve story, and then the market sort of pushed him into, “That neutral rate that you are thinking of is too high.” The traditional Phillips curve group as we know has not been forecasting very well. They have been saying for years that we are about to get wage inflation and we haven’t. So that group is a little discredited. I totally agree with you that the short rate should be lower, and the neutral rate is lower, and the Fed has been really slow at recognizing that level.

That said, how weak are we? It is true investment has been slow, housing has been slow. In a way the details of this report are not great. There was also more inventory accumulation than expected, which is also a detail that does not bode well for the future. That is another reason why I think the doves have a great case for continuing to move the rate down. Do you think this will lead to negative real GDP growth, David, in the next two or three quarters? Or will we just have what we sometimes call a growth recession, which is zero to 1% GDP growth?

Rosenberg: I wouldn’t be surprised if, in the next three to four quarters, we see a flat to negative print. This coming recession is not going to be defined by the magnitude or the peak-to-trough weakness in GDP as much as the duration, and how difficult it will be for monetary and fiscal policy to get us out of this. I would say this much without getting into whether or not we get a negative number, which ultimately may get revised anyway. I can’t believe how many people today [are] talking about how we can breathe a sigh of relief because there is no recession. Again, these are coincident numbers that we are looking at right now. They don’t give us much of a window into the future. Looking at data back to 1948, [from 10 different recessions in the post-World War II experience,] you would be surprised to know that in the quarter before [or in the quarter of] the recession, GDP isn’t negative. … The median GDP growth rate for that quarter is 2.4% and the average is 3.2.%.

“This economy is not out of the woods by a long shot.” –David Rosenberg

Siegel: I agree with you 100%. In fact, it is months and months later when they actually call the turning point. The turning point of the last recession — if I remember correctly, Dec. 17, 2007 — is the NBRE (National Bureau of Economic Research) peak of the last business cycle. In December 2007, no one thought there was a recession, or even one on the horizon. In fact, the Fed meeting said there was no recession coming up. So, with that said, when we look back, could this be the turning point? It definitely could. As the data are coming in, it doesn’t look like July was maybe the turning point. But you’re absolutely right; the latest GDP number provides no relief to say there isn’t a recession coming up. Now, I don’t see one. I also think that the Fed has enough silver bullets — [Fed rates] are enough above zero. They can go back to QE [quantitative easing]. None of this will solve everything, but they certainly have far more latitude than the Japanese or the Europeans by a mile if we do actually see a downturn. I don’t think there is going to be a downturn that severe unless we get a trade war. I don’t think that is going to happen because of political reasons.

Rosenberg: The economy is weaker than most people think. We had first quarter growth at 3.1% and second quarter growth was 2.1%. If you strip out the effects of the savings rate drawdown and the effects of government spending, the economy actually was close to 0% in the second quarter. I think the Fed will be cutting rates pretty aggressively over the next year. This economy is not out of the woods by a long shot.