It’s an old political trick. Engineer a recession in your first year and blame it on the previous occupant of the White House. Then take credit for the subsequent recovery.
President Donald Trump and Treasury Secretary Scott Bessent recently rattled the markets with the same message of short-term pain for long-term gain. Bessent began with a CNBC interview outlining the Trump Administration’s intent to shift the source of economic growth from the public to the private sector. He added, “The market and the economy have just become hooked. We’ve become addicted to this government spending, and there’s going to be a detox period.”
In a separate interview, Trump said “a little time” may be needed for his tariff plan to start returning wealth to Americans. He acknowledged that the U.S. economy will undergo some short-term pain and declined to rule out a recession this year: “I hate to predict things like that. There is a period of transition because what we’re doing is very big.” Even more alarming to equity investors, he revealed that he wasn’t as concerned about the stock market as he had been during his first term in office: “Look, what I have to do is build a strong country. You can’t really watch the stock market. If you look at China, they have a 100-year perspective.”
So long to the Trump Put.
Could this “detox period” result in a recession in 2025? This matters because, as
Callum Thomas observed, non-recessionary pullbacks tend to be short and shallow, while recessionary bear markets tend to see drawdowns last longer and deeper.
Here is what I am watching.
What to Watch: Business Confidence
Let’s start with the good news, I wrote last week that my current forecast does not call for a recession (see Tops Are Processes). My long-leading economic indicators can be broadly grouped into three categories. The consumer and household indicators look a little wobbly. However, the corporate sector remains healthy, and so are financial conditions. The combination of these factors doesn’t point to a recession right now.
What could change that forecast?
Let’s start with the corporate sector. Trump’s on-again-off-again tariff policy has shaken business confidence and made it difficult for corporate executives to plan, which puts downward pressure on capital expenditures and hiring.
The NFIB monthly small business survey is an especially effective window into business confidence. Small businesses are important barometers of the economy as they lack bargaining power, and most small business owners are small-c conservatives who have historically supported Trump in the past. The latest readings show that small business optimism has receded since the election.
On the other hand, uncertainty has risen to nearly all-time highs.
More ominously, prices have ticked up, indicating rising inflationary pressure.
When asked if this is a good time to expand, small business owners’ outlook deteriorated sharply after a post-election euphoric surge.
The Transcript, which monitors company earnings calls, summarized the latest mood as heighted uncertainty:
Capital markets have hit a patch of volatility thanks in large part to volatile policy shifts from the Trump administration. When things change in an instant, it makes it hard to plan for the longer term. Confidence appears to be thinning among both business leaders and consumers. Meanwhile, Jerome Powell sees no reason to rush anything.
Surveys of CEO confidence in big business has also shown a similar reversal in confidence.
While these developments are concerning, there is no need to reach for the alarm button just yet. Monitor the evolution of earnings estimates, which are still rising, and the forward P/E, which has declined to just above the 5-year average.
While bottom-up aggregated forward 12-month EPS estimates are rising, there are some concerning developments from a top-down perspective. Historically, top-down strategists are quicker to react to changes than individual company analysts, who don’t change their estimates until they can fully quantify the effects of macro shocks.
Super-bull strategist Ed Yardeni, who had a S&P 500 target of 7,000 by year-end, pulled back on the odds of his “Roaring 2020s” scenario of a resilient economy and improving productivity, and raised the odds of a flash crash this year. Yardeni also reduced his year-end S&P 500 price target by maintaining his earnings estimates, but cut the forward P/E multiple owing to the “the potential stagflationary impact of the policies [of] Trump 2.0”.
MarketWatch also reported that Goldman Sachs strategist downgraded their S&P 500 forecast based on a small cut to earnings estimates and a cut to the expected P/E multiple because “slower growth suggests lower valuations on a more sustained basis”.
I interpret these as early warnings of a deterioration in corporate profits conditions and falling business confidence. From a big picture perspective, corporate profits have been rising as a percentage of GDP (red line) while labour compensation (blue line) has been falling since the COVID Crash. It’s difficult to see how much upside there is in the corporate profit share in light of its already historically elevated condition without triggering social unrest.
It’s still an open question, however, whether these developments are enough to push the economy into a recession, or just a slowdown.
What to Watch: Financial Conditions
The other set of factors to watch are financial conditions. Financial conditions are neutral to easy at the moment. Even though the Fed has signaled that it is prepared to be patient on making a decision to cut rates, the market is penciling in three quarter-point rate cuts in 2025.
More importantly, inflationary expectations are well-anchored. The 5-year breakeven rate derived from the bond market is elevated, but within historical ranges.
High yield financing costs, which is a real-time estate of the equity risk premium, are not showing signs of stress.
In conclusion, the market’s risk appetite was recently dented by a heightened fears that Trump is engineering a recession. My analysis of current economic conditions shows low recession risk and my base case calls for a growth scare. If I had to guess, I estimate recession odds at one in three. I will continue to monitor the evolution of changes in business confidence and financial conditions to measure future slowdown risk.
Junk bond spreads are blowing out. Take a look.
https://fred.stlouisfed.org/graph/?graph_id=582384&rn=562
This is my favorite indicator of corporate stress.
My most trusted Strategists are saying the soft data as in the opinion poles like the ones above show big negative surges. They are concerned there will be a wall of negative hard data to follow since MAGA confusion is leading to consumers and businesses to suddenly stall retail buying and capex. This will be when their new 30% recession probabilities turn to 100%.
Ken, Thanks for another perspective. I would guess that your clients are mostly in cash equivalents or soon would be.
Cam is at 60/40 and carefully watching.
It’s difficult at best to make big moves like you are able to do.
I read recently that CCC bonds make up a smaller portion of the junk bond index. What impact would that have on the analysis?
The CCC is just an indicator of stress. It shows when weak companies stop being propped up and start to fail. This shows loan risk is rising to a level that impacts corporate lending decisions all across the board. This coincides with recessions.
You can imagine how defensive I am with portfolios with this view.
There’s a big difference if you zoom out to a 5 or 10 year time horizon. Spreads are elevated but “blowing out” is an exaggeration.
Very true. I should have said “lifting off”.
I do note that shares in Apollo and other private credit and equity providers are crashing over the last five weeks. Something is rotten in Denmark.
thank you for this, Ken. I sold last week and have been feeling slightly foolish ever since. Good to be on your side of the fence.