The Big Economic Risk Wall Street Isn't Talking About: Stephanie Pomboy

Q&A May 23, 2022 at 04:37 PM

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Stephanie Pomboy digs around to find risks and opportunities where others fail to tread.

Right now, the founder and president of the economic research firm MacroMavens is forecasting a profits recession, marked by a "huge margin squeeze for the average corporation."

It will be a significant price squeeze not experienced since the 1970s, as she tells ThinkAdvisor in an interview.

Gutsy and prescient, in 2002 the economic analyst predicted the housing bubble's imminent inflation long before others saw it. In 2007, she foresaw the worst financial crisis since the Great Depression.

Last year, Pomboy warned of a stock market crash.

Her profits recession forecast is based on fact: Input costs have been "outpacing the ability [of corporations] to pass them on," she argues.

Indeed, "the relationship between input costs and consumer prices is so integral to the outlook for the stock market," she says.

Pomboy contends that the Federal Reserve's monetary and fiscal stimulus during the worst of the coronavirus pandemic did little to increase economic activity but instead, did much to create "a massive bubble in financial assets," which now, as a result of the stimulus withdrawal, is starting to deflate, she says.

In the interview, Pomboy, whose clients include investment firms, mutual funds and hedge funds, among others in and out of financial services, maintains that today's primary risk is that the Federal Reserve will "belatedly ransack inflation."

Diving beneath the surface of existing trends, she analyzes economic and financial market data to find and interpret subtle signals for shifts.

That is, she seeks what's not priced into the market, then forecasts the implications.

Pomboy launched MacroMavens 20 years ago after a decade working with Ed Hyman at C.J. Lawrence and ISI Group. She picked up an economics degree from Dartmouth College in 1990.

She produces two weekly reports covering risks and opportunities, one for institutional investors, the other for retail investors.

Her podcast is "The Super Terrific Happy Hour" ("business, finance and economics, with a side-order of skepticism"), which she cohosts with Grant Williams.

ThinkAdvisor interviewed Pomboy on May 17. She was speaking by phone from her base in West Palm Beach, Florida.

She noted that no one else seems to be forecasting a profits recession because Wall Street "take[s] whatever the companies say as gospel until they say otherwise. No one is looking ahead."

Here are highlights of our interview:

THINKADVISOR: What are you discerning from your analysis of the economy and financial markets?

STEPHANIE POMBOY: There's the very real prospect of a profits recession. Yet nowhere on Wall Street is anyone forecasting this. It seems to be it's a no-brainer.

The relationship between [corporate] input costs and consumer prices is so integral to the outlook for the stock market.

And right now, the input costs have been far outpacing the ability of [corporations] to pass them on.

What are the implications?

I'm looking at the difference between the two and seeing an implied margin squeeze for the average corporation. We've never seen a squeeze this huge other than in the 1970s.

I'm talking about real pressure on corporate profit margins.

Will there be indications of a profits recession on current earnings reports?

Just because input costs are going up faster than corporations' ability to pass [them] along, doesn't mean this immediately hits current earnings reports. It takes a while for it to show up in the actual earnings numbers.

So it will take time for the commentary from companies to filter into Wall Steet strategists' forecasts.

Why is no one else forecasting a profits recession, as you say?

No one is looking ahead. They just take whatever the companies say as gospel until they say otherwise.

Wall Street focuses only on what the companies say. They wait for them to say [for example], "Here's our guidance for the next quarter."

What's the primary risk that you perceive?

The Fed is going to belatedly ransack inflation. This is the main thing that has the stock market anxious.

You'll see the stock market continue to come under pressure if the Fed continues to move rates up.

Most people are saying, "They'll raise rates, and the economy will have this, sort of, soft landing. It will slow, and everything will be perfect."

I think that expectation is just fantastical, to put it nicely.

Can the Fed trigger a recession by raising interest rates?

It remains to be seen whether we're in a recession right now or not. In the first quarter [real GDP growth fell at a rate of 1.4%].

If we do that again in the second quarter, even by the barest margins, technically we will have accomplished the definition of a recession.

The Fed got religion about inflation right when it was about to take care of itself anyway because consumers already ran out of the money with which to sustain their spending on everything at higher prices.

It's kind of a classic Fed blunder.

What's the economy's state of health?

The idea that the Fed can raise rates without precipitating a recession is rooted in a misapprehension about how strong the economy really was to begin with.

When you take out the amount of money that was handed to consumers to spend, a different picture [emerges] about the inherent strength of the economy and the ability to withstand the stimulus withdrawal.

But the consensus has been that the economy is strong. How do you reconcile that with what you're saying?

One of the things the Fed and Wall Street have underestimated is the degree to which the strength of the economy that we saw in the last couple of years was entirely a function of the monetary and fiscal stimulus, which totaled roughly $10 trillion.

We put $10 trillion into the economy, but GDP grew only $2.3 trillion. With inflation, you come up with $600 billion real growth.

It's sad how little actual increase in economic activity we got for all that stimulus.

What we did get was a massive bubble in financial assets, which is now starting to deflate because we're taking the stimulus away.

You write that the asset bubble is now deflating and "we can expect spending to slow materially, squeezing margins and depressing hiring." Please elaborate on consumer spending.

For so long, real wealth and "phantom wealth" have been the tail wagging the dog of the economy. When there's a positive wealth effect, consumers ramp up spending and have a higher tolerance for accepting higher prices.

[Just so], when the reverse happens and their net worth starts to decline, they pull back on spending and on their willingness to abide higher prices across the board.

And this is happening now?

We're getting into that situation now, in part, because policy suggests that energy prices, for sure, and food prices, maybe to a lesser extent, are going to remain elevated.

So even as people start seeing their 401(k)s going in the wrong direction and have the impulse to cut back their spending, they're still going to be paying more and more for everything they can't live without.

Please discuss what you see happening in the consumer discretionary space and what it means.

Earnings there are the weakest growth of any of the S&P sectors right now.

People have already drawn down a lot of their surplus savings. They're now below what they were pre-pandemic. So they've ramped up their credit cards, which at 16% interest, no one is doing because they want to.

How serious is this scenario?

People are already searching their sofa cushions for change so they can keep up with the rising cost of living. That's going to require them to essentially cut back on everything they don't need anymore.

So you're seeing more discretionary [spending] starting to go away. And I think you'll see a lot more of that.

Please characterize consumer spending behavior overall.

Since the last batch of stimulus checks went out in March, we've seen consumer credit card borrowing do a complete U-turn.

Consumers were paying down credit card debt with their COVID stimulus all the way through. But when the checks stopped, they started ramping up credit card balances.

At the same time, they started depleting all the savings they had built up during the COVID bonanza.

Personal savings is actually below what it was before the pandemic. So consumers are resorting to what I would describe as desperate measures to keep up with the rising cost of the basic necessities of life.

Still, many unemployed people have chosen not to go back to work. Please explain.

That's starting to unwind. We might see a real increase in labor force participation. We had that situation with the housing bubble in 2005-2007, when there was a huge exodus out of the work force as household net worth went up.

People took early retirement; but when the bubble burst, they ended up going back to work.

You anticipate a profits recession. In view of that, will jobs be as plentiful as they have been?

Profit margins are the number one input into hiring plans. You don't run out and expand your workforce if your profits are under pressure.

What impact will the Fed's shrinking its balance sheet have on the stock market?

It will have a very meaningful negative impact as well as the earnings story, which is a shoe that hasn't yet dropped.

Expectations are for 10% earnings growth this year, and a recession is forecast.

So there's a lot of risk to the downside of the stock market.

How far will it go?

That depends on whether [Fed chair Jerome] Powell stands back and lets the market collapse, or if he says, "We've got to dial back our rhetoric" because the impact of a stock market bubble bust would be to put the economy in recession anyway.

It's going to come down to how much pain the Fed is willing to take.

I would suspect that they aren't going to take a whole lot of pain, mostly because they're very skillfully using jaw-boning to great effect.

Meaning that they mainly just keep talking about interest rate increases?

Yes. It has saved them from having to do a lot of actual rate hikes. They've barely raised interest rates, but the market has built in massive rate hikes.

So they managed to get that accomplished without having to turn the screws very much.

What effect do you think the midterm elections will have on this picture?

As we get closer to November, I would imagine the tolerance for any real pain in the stock market, which would blow back to the economy, will diminish dramatically.

I think that Powell is feeling emboldened to tackle inflation because the administration said [essentially], "The inflation problem is our Number One political liability. We want you to do what you have to do to nip it in the bud."

But if we get to September and the stock market is down 40%, they might decide that [inflation] isn't as important as our reining in the financial markets.

What else is informing your view about risk?

The chart of long-term bond yields. Every time we get a little bit north of 3% on the 10-year Treasury, not surprisingly, things get pretty squirrely in the stock market.

So I think the threshold for interest-rate pain is far below what most investors perceive it to be.

You write about a shortfall in pension plan funding. What are the implications?

After the global financial crisis, the Fed recommended that [investors] start stretching for yield and that they become a little more aggressive in risk-taking if they wanted to get anything resembling a decent return.

What did that mean to pension plans?

It was really a problem for [managers]. They had these other-worldly mandates where they were supposed to generate 8-plus percent annual return on their pensions.

So [they] had no choice but to hold their noses and buy everything you wouldn't want to touch with a 10-foot pole, like junk bonds and levered loans.

When they ran out of those, they got into quote-unquote alternative investments, which are apparently in some other universe where 8% returns grow on trees.

Essentially, these ended up being highly levered and risky.

What will happen with the pension plans if and when the risk bubble bursts?

The people that are going to get left holding the bag are the pension funds because they were the marginal buyers of all the most toxic stuff.

But [since] the Fed bailed out Wall Street after the global financial crisis, there's no way they can't bail out Main Street after the pension bubble bursts — especially since it will have been their fault, to put it bluntly, that the pensions ended up in this horrible situation.

Do you think they'll have to bail them out?

The Fed is going to have to go back to its usual bag of tricks and support the market, if only to make the pensions hold so they don't have to bail out $10 trillion in pension liabilities that are unfunded, which will require them to re-up quantitative easing and expand the Fed's balance sheet anew.

The odds that we see a Fed balance sheet at $16 trillion are much higher than a Fed balance sheet at $7 trillion.

Are there any investment opportunities at all that you see in the market?

When you get into a risk-off period like we've been in for the last few weeks, even things that you'd think would act defensively, like gold, have been, sort of, cast aside, presumably because right now everyone is trying to reduce their exposure across the board.

They're unwinding leverage and taking down exposures, and that requires basically selling everything.

So you see nothing to invest in that might generate something positive down the road?

You have a little air pocket where the best you can do is hope to outperform on a relative basis, like being long on defensive things, like gold or oil.

I would even say some emerging markets will hold up. They'll get hit less.

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