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March 19, 2022, 8:58 a.m. EDT

Prepare for a recession this summer, a bear market in real estate and a drop in stock prices, warns strategist David Rosenberg

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By Jonathan Burton

Inflation has turned out to be not-so-transitory, and the Federal Reserve has its knives out. Well, its hammer, anyway.

Raising interest rates — the U.S. central bank’s primary tool to restrain runaway prices — is a blunt instrument, at best, and until now, Fed Chairman Jerome Powell has been reluctant to reach for it, let alone use it.

David Rosenberg expects the Fed’s attack on inflation, which began Wednesday with the first of an anticipated series of interest-rate increases, to slay the U.S. inflation dragon — at a high cost.

Investors accustomed to easy money and meteoric gains in stocks, real estate and other rate-sensitive assets understandably hope for and even expect the Fed to engineer a Goldilocks-like soft landing for the U.S. economy.

But Rosenberg, the widely followed president and chief economist and strategist of Toronto-based Rosenberg Research & Associates Inc. , is convinced that the Fed will beat inflation so hard that the U.S. economy will slide into recession as early as this summer.

In fact, Rosenberg sees evidence of a slowing economy already, which for him makes the Fed’s timing questionable and only amplifies his recession call — a cycle that may not end with just one recession. It took two painful recessions, in 1981 and 1982, for then-Fed Chairman Paul Volcker — the patron saint of inflation fighters and Powell’s role model — to bury a decade’s worth of inflation and resurrect the U.S. economy and stock market.

Rate increases depress demand, but when taken too far, crush it. The resulting recession is negative for home prices, consumer-discretionary stocks and nice-to-have goods and services, and positive for Treasury bonds and the producers and purveyors of consumer staples, health care and medicine, energy, food and other things people need to have.

Investing under such conditions is challenging and selective, but investors must play the hand they’re dealt. Earlier this week in a telephone interview, which has been edited for length and clarity, Rosenberg detailed his recession case and suggested where to put your money so you have a chance to profit from whatever cards Mr. Market turns over.

Unsurprisingly, Rosenberg’s economic and market outlook is not popularly shared at the moment. But as he likes to say: “Forewarned is forearmed.”

MarketWatch: Inflation concerns are front and center. Recession is distant and downplayed. Yet you have just published a “recession tool kit” for investors. Why now?

Rosenberg: The timing came from Federal Reserve Chairman Jerome Powell. A couple of weeks ago, Powell said [former Fed Chairman] Paul Volcker was the “greatest public servant.” That’s all you have to hear. How did this greatest of them all kill inflation? Through back-to-back recessions in the early 1980s. Volcker is credited for ushering in a secular two-decade long bull market and economic expansion, but only by destroying inflation through back-to-back recessions.

It would be wonderful if the Fed was adept at growing food and pumping oil and resurrecting broken supply chains, but the only way the Fed will be able to curb the cost-push inflation we have right now is through a recession. It’s going to take demand destruction to get inflation down.

MarketWatch: “Demand destruction” means bursting asset bubbles and that typically means lower valuations for housing, stocks and other cherished investments. You’re on record about residential real estate being at “peak housing.” What convinces you that the U.S. housing sector is in a bubble?

Rosenberg: The housing market is in at least as big a bubble as the stock market . When you look at price action, it’s absolutely incredible. The year-over-year trend in nationwide home prices is 19%. We’ve already taken out prior bubble peaks in the late 1970s, mid-’80s and mid-2000s.

Relative to overall inflation, housing is overvalued by 35%, and 27% relative to wages. Home prices relative to residential rents are 25% overvalued by the standards of the past. A single-family home now absorbs more than eight years of Americans’ personal income, which is almost 50% higher than the average going back to 1968. In a normal market it takes five years of income to buy a single-family home.

Housing, like equities a long-duration asset and benefitting from years of accommodative monetary policy, is again ensnared in a mess of a price bubble. The price-to-income multiple is just about where it was in 2006 and 2007. Nobody wanted to believe it then, and talking about housing being in a bubble today, it’s as if I told somebody that their kid was ugly.

MarketWatch: How hard could this next recession hit U.S. home owners?

Rosenberg: Historically, home prices go up one- to two percentage points above the inflation rate. Right now it’s going up 12 percentage points. Residential real estate is a great hedge against inflation. But the excess is practically unprecedented. The laws of mean reversion are telling you that we’re going to have anywhere from a 20% to 30% bear market in residential real estate, and that’s being charitable. And once again, nobody seems to believe it, let alone prepare for it.

What ultimately pulls the rug out from under the housing market is the Fed, because housing is the most interest-rate-sensitive segment of the economy. Each Fed-induced pricking of the real-estate bubbles also played a big role in the eventual recession when you consider the importance of this sector and its multiplier effect on the broader economy. You can’t think that housing is going to respond to a rising rate cycle in the same way it responded to a declining rate cycle.

Fed steps, missteps and delays

MarketWatch: The Fed is raising interest rates now to cool inflation and guide the economy to a soft landing. How much confidence do you have in the central bank’s ability to achieve this?

Rosenberg: The Fed hiking rates usually leads to bad things for the economy. The Fed’s ability to guide the economy into a slowdown without generating a contraction is a one-in-four bet, historically. We have the Fed right now hiking rates into a flat yield-curve and into super-elevated geopolitical risk and a very wobbly capital market. Real rates, which give you a view of what the bond market is telling you about growth, is now heading deeper into negative territory. The only reason why nominal bond yields are going up is that inflation expectations have really taken off. Real rates are going more negative.

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Jonathan Burton is the investing editor for MarketWatch and covers investing strategies and mutual fund-related news from San Francisco. He also writes the...

Jonathan Burton is the investing editor for MarketWatch and covers investing strategies and mutual fund-related news from San Francisco. He also writes the "Life Savings" column. Previously he held contributing editor positions at Bloomberg Personal Finance, Mutual Funds and Individual Investor magazines, and was a reporter with the Far Eastern Economic Review and Investor's Business Daily. He is also the author of two books on investing.

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