The text below is a transcript of audio from Episode 24 of Onward, "The case for a recession."
Disclaimer: This transcript has been automatically generated and may not be 100% accurate. While we have worked to ensure the accuracy of the transcript, it is possible that errors or omissions may occur. This transcript is provided for informational purposes only and should not be relied upon as a substitute for the original audio content. Any discrepancies or errors in the transcript should be brought to our attention so that we can make corrections as necessary.
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Cardiff Garcia:
Hello and welcome to Onward, the Fundrise podcast where you can find out more about what's happening at Fundrise and where you'll hear some in-depth conversations about the big trends affecting the US and global economies. This is the, Settle Down Everybody! The case for short-term pessimism, episode.
We are recording this on Thursday, June 29th, 2023. Please keep rating and reviewing the show in those podcast apps. We love it when you do that. We love hearing from our listeners. And of course, we like to remind everyone that this podcast is not investment advice, it's informational. We hope it's entertaining, and it is for those purposes only.
And with that, let's get on with what's going to be a really exciting show. I'm Cardiff Garcia, of Bazaar Audio and I'm joined, as always, by co-host, Ben Miller, CEO of Fundrise, the Pessimist in Chief. Ben, how are you man?
Ben Miller:
Thanks a lot, Cardiff.
Cardiff Garcia:
Ben, you came to me with this idea for this episode, which was to explain to people why, even though a lot of the recent data's been looking good in the US economy, there actually is a very strong case for pessimism. Why don't you just start by giving us your justification for that? Why do an episode like this?
Ben Miller:
Pessimists got a bad name here.
Cardiff Garcia:
That's true, actually.
Ben Miller:
Maybe I'm a optimistic skeptic.
Cardiff Garcia:
We'll go with that.
Ben Miller:
So my job is to get to conviction, that's my actual day job. And I want to make the case today for a recession, that the recession is coming. And the reason I want to do that is why be a pessimist around this topic. The reason I wanted to make this case is it speaks to something you and I have talked about. You've even said you've learned something from our conversations.
My job basically, is to take risks. We invest, we hire, we spend, we buy assets, we sell assets, we finance, all of those decisions, all those actions assume risk. We're in the fight. Well, so risk is probability times magnitude. I think people forget about the magnitude part, they focus on the probability. I went through the tech downturn in '99. I was working in tech in '99, and I was working in real estate in 2008.
Cardiff Garcia:
Oh, my.
Ben Miller:
So I have a very visceral sense of what it means to experience the downside. That's why I'm basically obsessed with recessions because they are make or break moments. And I was actually thinking about how people who are in the workforce, you really would have to be in your mid-forties to have deep professional experience with a recession. It's not like if you graduated in '07, you maybe had a recession but you didn't have any kids, you didn't have any employees, you didn't own a house. And so it's a very different type of experience being later in your career and going through a recession.
And so there's a lot about the next few years that I think are going to be painful, but actually a tremendous learning experience for the country. And what '08 and '01 taught me was those recessions are the make or break moments. They're everything.
Cardiff Garcia:
And I want to point out, we're talking here about recessions not caused by something like Covid, which in some senses came out nowhere and that recession only lasted a couple of months. There was a recession and young people did experience it, but it was unusual. It wasn't something that originated in the economy itself, like the '01 or the '08 recessions, both of which had quite sluggish recoveries.
And if you lived through those times, as you and I did, just to date the two of us, if you did, then you might have a very different understanding of what it is to actually confront a recession versus if, let's say you graduated from college or you entered the workforce, if you didn't go to college sometime within the last 10 years. Sure, you had the Covid experience, but you haven't gone through the kinds of recessions that you and I are discussing right now.
Ben Miller:
I'm even saying maybe the last 20 years. So you can't really explain to somebody how difficult they are till they actually experience it. I was trying to come up with an analogy and I came up with, you spend all your time cooking in your kitchen on a gas range stove and then all of a sudden somebody takes you out into the wilderness and you have to cook over a fire you have to kindle, while it's raining.
That's the difference between a recession and a normal economy. Everything becomes so much more difficult in all these subtle ways that you just take for granted when things are normal or even great. They've been great the last few years from an economic point of view. Okay, that's the reason I want to do this podcast.
Cardiff Garcia:
Excellent. Okay. Well, I think one thing we could start by doing is to set up the contrast between what's been happening lately versus your prediction that we're headed towards a recession sometime within the next six to 12 months. And I want to start with where we are right now, precisely because all the numbers coming in recently have been positive.
I was just reading something from Bloomberg yesterday and I'm just going to list some of the indicators that have come in this very week that have shown up blowing away expectations or at least exceeding them. All right, purchases of new homes, durable goods orders, consumer confidence is bouncing back, house prices even, retail sales, consumer spending. And of course we have the job market which is still creating hundreds of thousands of jobs every single month. And on top of that, on the very day that we are recording this, we got the new estimates for GDP in the first quarter and it was revised up.
So GDP grew and annualized 2% in the first quarter of the year, which is traditionally fine for the US economy. That's a traditionally normal number. So you look at all of these indicators arriving now and you have a lot of people, a lot of economists, a lot of economy watchers updating their views to say, "Okay. Well, maybe we're not headed for a recession after all." Because just a few months ago people were more pessimistic and now people are becoming more optimistic.
That doesn't apply to you, but it certainly has been borne out in the data to this point that our worries, including yours and mine earlier this year have not yet been born out. So let me just start with that. Are you surprised by the indicators that have shown up so far and given that you're expecting a recession, are you surprised that it's taking longer to get to that point than maybe you'd anticipated before?
Ben Miller:
That's why I wanted to do this episode because I was confused. So I had been preparing for our mid-year letter to all of our investors, so I started doing research trying to figure out what the heck is going on here because this doesn't make sense. And I want to walk everybody through that, but the research helped me understand what's happening. I completely agree with you. Everything's looking pretty good right now. NASDAQ's up 30% S&Ps up 14.5%. New home sales are up 29% since one year ago. Payroll is continuing to produce huge number of jobs, unemployment's 3.7%, everything's great.
Cardiff Garcia:
And inflation falling, let's not forget that one, headline inflation falling.
Ben Miller:
Headline inflation falling and the only bear out there is, Jay Powell, Fed Reserve Chair.
Cardiff Garcia:
To be fair, it's Jay Powell, worried about inflation in terms of bearishness on the economy itself, there's actually still some folks out there again, updating their views. But I think Wall Street economists generally are still worried about an eventual recession. And in a minute we'll get into some of the reasons possibly why, but there's fewer of them worried about it now and everybody else is essentially taking a moment to say, "Aha. See, you guys, you worry warts, we're still growing at a decent pace. Inflation is falling."
Jay Powell, still says inflation is too high and they have to keep raising rates, maybe at a slower pace as before, but you got to keep raising rates. So he is still worried about inflation. But overall, I will give you my own perspective on this, which is that I am surprised to this point by the resilience of the economy.
My best guess at the end of last year was a very soft landing where growth would slow, maybe not tip into recession, but it would be really weak and that the labor market in particular by now would be weaker than it was. So I've been surprised that the US grew by as much as it did in the first quarter and in particular that the consumer is still spending so much money into the second quarter of the year. Which is why it looks like the second quarter of the year is also fine.
So I've been personally, I don't want to say shocked, but I guess pleasantly surprised because a good healthy economy is great for everyone. But in general I've been looking at this data and thinking, "Oh, I guess I just had it wrong earlier to have been so worried."
Ben Miller:
Yes, I was confounded as well because on the ground I'm seeing lots of signs of slowdown. But in the headline data, I'm seeing tons of positive signal and even numbers that are in such extreme conflict, some of them I don't even understand. So it set me off on this journey maybe to try to figure out what was happening. I think I have a pretty good beat on it and I sum it up as, Don't fall for the trap.
Cardiff Garcia:
The head fake, you think it's a head fake. All this new data is a head fake.
Ben Miller:
This is a serious head fake. There's leaves and branches over this pit.
Cardiff Garcia:
That we're all about to fall into. We're like bears roaming the woods not realizing that some trappers have laid all these leaves and branches over this enormous hole we're about to fall into. Okay, fair enough.
Ben Miller:
Hopefully you'll lay out the things you're still worried about or maybe some of the short-term pessimistic indicators.
Cardiff Garcia:
Let me start with two quick ones, but important ones. The first is simply that the yield curve has been inverted since the end of last October. So if you want to call it the... all of November through now, that's what? Nine, almost 10 full months of a yield curve inversion. And I go, by the way, by the 10 year and the three month, I don't go by the longer ones like the 10 year, two year. I go by the 10 year, three month. That's the one that the original finance theorist who came up with the recession predicting abilities of the yield curve, Campbell Harvey, follows as well. And it's been inverted for so long and the inversion continues to steep it. When I look at that, I start to wonder, "Are we just due?" And typically there's a fair amount of lead time, 12 to 18 months before the recession starts and we're not there yet. Okay, so start with that.
Second, I follow the conference board's leading economic indicator index, the LEI. And it has been negative for 14 months. That has only happened three times before and all three of those times by the 12th month we were already in a recession. Which means you'd have to have two streaks that were to end if we avoid a recession this time. One is the yield curve inversion streak, which goes all the way back to the 60s and second, the economic leading indicator index that I just mentioned, which also goes back decades in the last three times that it was negative for this long, there was a recession.
So I look at that, start there. Forget about coincident indicators, which are all the positive things we've had recently. Leading indicators are giving me a lot of reason to be nervous about what might be coming in the second half of the year or maybe even as far down as the early part of next year. I'm not sure about the timing, but I'm really worried about that. So I'll start with those. There's other more detailed things we can get into, but let me throw it to you now because the one who's been on this journey and doing all this research. And I love that you're teasing the mid-year newsletter here. That's always fun to get a little bit of early information and I think listeners are going to appreciate it as well. So what are the reasons why you're worried that we're still headed for a recession?
Ben Miller:
Well, I was having cognitive dissonance because on the ground I'm seeing recession and in the air I'm seeing ascension. Huge positive headlines. So let me talk about what I'm seeing on the ground that made me pessimistic. We're in real estate, we're in finance, we're in tech. We cover a lot of the market.
So I was up in New York a few weeks ago and I met with a ton of big institutions and banks and also we have 20,000 residential units. We have industrial. So I really see a lot of what's happening on the ground. So I'll give you a few vignettes here. One of the things interesting is I came away from meeting with basically almost every major institutional investor that is in the build-for-rent space, institutional funding built-for-rent, and which is building new communities of homes for rent.
Cardiff Garcia:
Which is one of the things Fundrise specializes in.
Ben Miller:
Yeah. We have almost 5,000 homes, 50, 60 communities, I think were the fifth-largest built-for-rent platform in the country. And so I was meeting with them and I found that none of them were writing checks, none of them were actually doing deals. What I saw firsthand is on the ground consequences of an inverted yield curve. Because inverted yield curve is an indicator, but why is it an indicator? Because if you're going to make an investment in building homes, or a factory, or investing in equipment, or hiring everybody, that's essentially an outlay of risk, time, energy. And the cost of borrowing now is eight to 10%.
That's the Fed funds rate plus what a bank would charge you, eight to 10% on the debt basically makes any real investment on the ground, totally uneconomic, it just absolutely off the charts on economic. And so all these big investment houses essentially are for us [inaudible 00:14:33]. That's one thing that in terms of a capital investment, and just to par sail a little bit, the reason why you're so right to use the 10 year, three month for the inverted yield curve, what that is it's the three-month interest rate, minus the 10-year interest rate.
Putting that into in a more real life experience is that in almost any type of situation where you're building something, making something happen, you're in motion, you're going to borrow short-term money that's floating rate. Basically the lender's going to say, "Well, I don't really know when you're going to be done with this. I don't know what economics are going to be." As the creator, the developer, the entrepreneur, "I don't know either." So everything's going to be floating and that's the three month, that's the overnight interest rate.
So that means basically you're going to be borrowing at the rate today that is five and a half plus a spread of probably three to 400 points, so that's 7, 8, 9, 10%. The long-term tenure interest rate is for things that are stable, fixed, done building. In real estate it's stabilized apartments or stabilized asset where everything's leased up. There's really not that much more economic activity left to be done. It's complete. The project's complete, the business is mature. And then you can go get fixed rate long-term stable debt.
But stable long-term fixed rate debt is not available to you when you're in motion. So that's why when you look at the inversion, you're really contrasting what the price of something is that's in motion ,price of financing it, versus something that's long-term fixed. And when it's inverted, it is basically saying the economic activity is punished, compared to basically not doing economic activity being stable. And that's what I'm seeing on the ground.
The examples of major institutions not investing in building homes. I was talking to a big one who was buying $200 million of homes from small home builders in the Sunbelt because those home builders can sell those homes because housing markets gangbusters, but they can't build the homes because they can't get construction financing. That's an example.
A major national shoe brand came to us to do an e-commerce facility because we have an industrial site. And over the course of the last three or four months, they've basically frozen that decision because they basically aren't sure they should make that capital investment. We do a lot of digital marketing, so the cost per click of our digital marketing search, like Google or social, Facebook, is down almost 50%.
All those things are... Well, I don't understand the headlines. I don't get this because the headlines are super positive, but what I'm seeing on the ground, there's no justification for a really, really optimistic view of the economy. So that's my microeconomic hat, if you will.
Cardiff Garcia:
Yeah. What's fascinating about this is that you're seeing the very real effects of higher short-term interest rates and you're seeing it immediately. And it sets up this clash effectively where there are parts of the economy that are healthier than they were going into previous recessions. Household balance sheets is the one that really stands out here in terms of overall debt levels, debt as a share of the overall economy and so forth. The consumer is still spending, but on the other hand, you also have these other parts of the economy that, as you've just described, are seizing up.
And so the thing that makes me worried is that if the parts that are healthy right now eventually start to slow or show signs of fragility, then essentially the parts that right now are seizing up will be the things that, on the margins at least, dictate where the economy's headed and that does mean a recession. Which of those two sides of the economy's actually going to win out? Who knows? That's why we let the future unfold as it does.
But if, for example, consumer spending just continues the way it has been, on and, on and, on and, on then maybe even with these higher rates, eventually you'll see some parts of the market unfreeze because they'll just see that there continues to be a lot of demand out in the economy. But if consumer spending does start to slow down at some point, if for example, the cracks in the labor market start to widen and that could happen, then I think you will see a pullback in consumer spending.
And then you have a problem because then higher interest rates are really going to start to bite. So I see the economy as having all these conflicting forces right now. And what we're trying to figure out in a chat like this, and in the research that you're doing, is which of these forces are going to prevail in the next six to 12 months?
Historically, higher interest rates, when they're sustained, do eventually bite, and the Fed usually is a little bit behind in terms of when it starts to lower them again. And that is one of the big things that I'm really worried about right now. We just haven't gotten to that point yet. These forces are still offsetting each other and in a way the forces propelling the economy have been winning to this point in the year. But there's a lot of conflict inside of the economy that's made reading these economic indicators so confusing right now.
And I'll give you one more example of some indicators that are also quite baffling to me, and they come at the very, very highest level of just output. GDP, I mentioned earlier, looks quite healthy right now. But there's another measure of the economy and how much it produces that should, in theory, equal GDP, it's called GDI, Gross Domestic Income, as opposed to Gross Domestic Product.
And the difference between the two is that GDP is measured by how people spend money and GDI is measured by how much money people and companies make. And theoretically, whenever somebody spends money, well you're giving that money to somebody else. So those two indicators should be identical, but they're not because of the way they're measured. So what a lot of economists do is they take an average of the two, well guess what? GDP looks healthy. GDI, the last two quarters, does not look healthy at all. It's declining and when you average the two, the economy's already flat. So we're not sure which of those indicators is actually more reliable, more accurate in the long term.
GDP is consistent with other things that are happening right now, like spending. But GDI is already negative and the average of the two, which again a lot of economists look to for a more generally accurate view of the economy, is already flat. In other words that the economy is already growing more slowly than we have been led to understand and maybe later revisions will bear that out. There's other things in the labor market that I also want to talk about, but let me first throw it back to you and just get your thoughts on everything that I just said.
Ben Miller:
So you're getting to the quick of it and why I went off on this journey because I was confounded by it, I was confused and so I spent a lot of time looking at the data because every time I am trying to understand the future, I look at the past. And so the problem is recessions are rare and there's not that much to guide them in terms of pattern recognition. Maybe you and I will have six or seven in our lifetime.
Cardiff Garcia:
Small sample size.
Ben Miller:
And the last one is 15 years ago and the one before that 20 some years ago, so two in 25 years, it's not that many. So I conviction now. And I'm going to give you the conclusion and then I'll give you the argument so it'd be easier for you to follow along and potentially challenge it. My conclusion is three parts. So one; it's the Fed that causes recessions. Two; there's a very long lag between interest rate hikes and the recession. And three; the losses from a recession are so significant that by far the most important thing over the next 24 months is to be prepared for that recession. And so I almost could coin a new phrase. I'm not going to do it, but I'm just going to give you a sense of what I would call it. I would call it, The Great Lag.
Because I think it's the lag that's really deceiving everybody. Let me go back to the data here, [inaudible 00:23:11] and so I'll start to make the argument. So I went back and looked at all this data and if you go back to 1954, which is when St. Louis Federal Reserve data starts for Fed funds rate, you can count the number of recessions. So nine, nine recessions since 1954, 1957, 1960, '70, '75, '81, '89, 2000, '08 and 2020. So nine since 1950 is not that many in terms of data points as you're saying. And I'm going to put aside 2020, it's too much of an aberration because of the pandemic. So I'm just going to put that aside for a minute. So guess how many of those recessions had major interest rate hiking cycles before commencement of a recession? How many recessions were proceeded by an interest rate hiking cycle?
Cardiff Garcia:
Was it all of them?
Ben Miller:
100%. Every single one. And I looked at every single one and just to highlight a couple because I feel like there's a few that are the most common parallels, people mention them, but 2004 to 2006, they raised interest rates from 1% to 5.25%, sounds somewhat familiar. In 1980 they raised interest rates from 9% to 19%, so 10% in 18 months. 1977, same thing, five to 13%. So I'm looking at every single one of them. Every single one of them had major interest rate hikes of between four to 10%. Big, big hikes.
And they all generally happened over the course of 18 to 24 months. So you basically have 100% of recessions had interest rate hiking beforehand of consequence. Our hikes are, in terms of magnitude, speed and proportion, are the top end of that. It's happened faster than most, greater interest hikes than most, and proportionally we're going to end up five point half percent or so, so that proportionally is probably the largest. So you're talking about all those recessions, the magnitude or significance of the interest rate increases are large, larger than average. So that's a piece of data.
Cardiff Garcia:
It goes back to the point that if a recession actually is avoided this time, it means that some very longstanding streaks are going to have to end. And hey, look, maybe that could happen. New things do happen, but at the very least it's a big cause for concern. And I want to make one other point that was provoked by what you just said, and in particular with respect to the 2020 recession, which was very short, it was caused by Covid, which had all of these massive other devastating effects on, not just the economy but on society.
And so therefore it sparked quite an aggressive response from policy makers, not just the Fed of course, but from the legislative brands, from Congress and from the president. And we ended up basically spending a lot of money to fight it and essentially it worked. That recession was incredibly short-lived and the economy got back to where we would've expected it to be before anyways. It was brutal and it took a lot of weird twists and turns and there was obviously things like last year's big inflationary spike, but the economy basically got back to where we thought it would be if covid had never happened.
But here's the problem. That recession provoked a very aggressive response. If a recession shows up in the next six to 12 months, that is very unlikely to happen just for political reasons. You already have debt levels that a lot of politicians and policy makers are uncomfortable with. And you have the president and you have a Republican house, and we're going into an election year, so it's very unlikely, at the very least, that Congress and the president would pass any kind of an aggressive package to fight a new recession.
The Fed might be able to act aggressively if it decides to lower rates, if it finally does agree that a recession is here and if inflation's low enough. But the fast response in the economy that you get when a big fiscal package is passed, you're not going to get that, or at least I should say it's very, very, very unlikely that in an election year, that if a recession shows up, you're going to get a big fiscal response. That's just a guess, but I see that as a high probability. And so the thing that made the 2020 recession so short-lived is unlikely to be an existing variable the next time.
Ben Miller:
There's a misconception that people have that because the Fed creates the recession, they can then stop it or reverse the recession. And I think that's largely wrong.
Cardiff Garcia:
Well, there's a lag on the way into the recession, but there's a lag on the way out of it too. That's the thing with monetary policy.
Ben Miller:
Because of lagging, which I want to get to, but also because of the fiscal stimulus that you not likely to have this time around because of the split control of Congress, like what we saw in '08, where there was split control and really didn't get proper fiscal stimulus. And also because the Fed wants to kill inflation, so they know that if they take their foot off the gas too soon or reverse it too early, they could see a repeat of 1980, which they call Volcker's Big Mistake. I think Volcker, called it his big mistake, which that he killed inflation in 1980, reversed his policy rapidly and dropped interest rates from 20 back down to 10 and inflation came back.
And so I think the Fed, I really believe the Fed and Jay Powell, historic legacy is to not make that mistake. And so you're likely to see them respond slowly to a recession and not try to bail people out from a downturn that comes from higher interest rates.
Cardiff Garcia:
I want to pivot to something else here because it's right in your wheelhouse and it's something that you and I have been discussing for quite some time. And that's the effects of the commercial real estate environment. You got into it a little bit just now, but we've seen a lot of foreclosures at this point. We've seen a lot of stresses in commercial real estate and a lot of speculation about the extent to which that might end up affecting other parts of the economy.
This has been such a slow motion train wreck that I wonder if we're failing to grasp the eventual accumulated damage that it might have on other parts of the economy, or maybe it just is the case that because it's happening so slowly that the economy can essentially process it a little bit more casually, I guess, because it's happening over a course of months or even years as opposed to all at once. But I have no idea. I'm completely baffled by why commercial real estate hasn't collapsed more than it has to this point and why that hasn't had more contagion effects on other parts of the economy. What do you think?
Ben Miller:
It's a good microcosm of the next thing I found in my data, which is the lag effect. I'll do it with an illustration and take it back up to the large scale. But anybody who has an office building, and I know lots of people with office buildings, they're looking at their maturity and they're trying to figure out how to extend it, how basically not to have the loan come due and foreclose on them. And the lender is also looking at that and nobody wants a foreclosure.
So what's been happening in the commercial real estate market is that you can go out and basically pull future low interest rates into the present. It's called basically a interest rate cap, or derivative that you can buy essentially as if interest rates were 2% rather than 5% or 7%. So you can basically create a synthetic interest rate and that's also called a synthetic debt service coverage ratio.
So you can basically manufacture a scenario that would allow the bank and you to essentially kick the can on the fact interest rates are now triple, quadruple what they used to be. Because the whole real estate world, and I think largely the financial world was expecting interest rates to fall. And if you look at the forward curve, which is the forecast of future interest rates, it's been forecasting that interest rates would fall rapidly for the last year, even the last 18 months, even from the start of inflation. There was this perception that it'd be transitory and the financial markets basically have this forecast that essentially that inflation would come and go and by kicking the can, they would get to the other side of it.
There's like a inverted deal curve. It's like this hill, if you can just get over this hill, then basically, you're not going to have foreclosure, you're not going to default. And the lender and the borrower, now all the market participants basically said, "Okay, well that's what we're going to do." So everybody did that. And so as a result, the Fed basically couldn't lower rates. The market's reflexive, the market basically behaved in a way that prevented inflation from coming down because they didn't actually want to have foreclosures and big problems. So they kicked the can, that cost a certain amount of money to kick the can.
So that's basically, in a way, why the lag is so tricky because what happens is everybody did that and that's what creates the lag. Essentially, everybody in the market is fighting a recession. Nobody wants to lose their job or lose their building, lose their house. It's a battle. And the Fed's on one side, they're raising rates and everyone else is fighting them. And that's the essence what creates a lag. And the thing that people don't realize is how long the lag is. I'll walk through that data, but that's why commercial real estate hasn't basically fully collapsed yet. It's a misconception that basically interest rates come back down and so they don't have to deal with the problem.
Cardiff Garcia:
Until enough players in the market realize if this is what happens, that interest rates have stayed high and then they've got a problem.
Ben Miller:
So if interest rates are higher for longer and they don't come down, you can't kick the can. There's no hill. It's just you climb to the top of a plateau and that's where you stay and then they're in default. Once the market realizes that, that's when the market collapses and that's when we're done. That's when we're on the other side. But until the market, it's like a catch-22, until the market accepts that interest rates are going to stay higher for longer, we're not going to actually be able to lower rates.
Cardiff Garcia:
That's interesting. I've also got a question about something that is, in some ways, a challenge to your thesis. I was really curious to know why Goldman Sachs economists were the big outlier on Wall Street. So they've only put the chances of a recession at 25%. The rest of Wall Street is up in like 60, 70, 80.
Ben Miller:
For what year?
Cardiff Garcia:
Within the next year or so, I think was the thing they were referencing. Will a recession start within the next year? So I listened to a podcast that featured one of their US economists. And one of the points he made was that everybody expects the strains in credit markets in particular to eventually have an effect, but that the difference between now and 2008 is that the financial sector is so much more diversified. If you're a business and you can't get a loan from a bank, you can get it from so many other places now.
And the thing I thought of was that Fundrise didn't exist in 2008 and it is itself a new financial institution. And one of the things that you've put forth is that you're looking to fill in the gaps in lending and the economy where you see opportunities when the market values get to where you find them attractive. And in some sense then by contributing to the diversification of the financial sector, Fundrise is the constitution that might itself be postponing the onset of a recession because it is another source of financing for the economy.
I wanted to get your thoughts on that and whether or not you think that's true that because the financial sector is a little bit more varied than it used to be, that it helps offset some of the strains in credit markets that you might get from higher interest rates.
Ben Miller:
I think I agree with what Goldman's saying, but within a different conclusion. I'll just walk you through this next set of data. This is true with every recession, including the ones in '57 and '60. But I'll give you '69 to 2007. So let me just make this point. The lag between hiking and recession is from the peak of interest rates to the recession. So we're not even at the peak yet.
Cardiff Garcia:
So in other words, if you think that interest rates are going to go up by 25 basis points another couple of times, the lag starts with the end of the rate hiking cycle.
Ben Miller:
The lag starts with the end of the rate hiking cycle. That's what the data says. The data says that the Fed will hit a peak of some interest rate number and stop. And then there's a lag of ranging between eight and 18 months from that peak across 1, 2, 3, 4, 5, 6, 7, 8, 9 recessions, all nine recessions, there was a lag. The average lag is 11 months, from the peak.
Cardiff Garcia:
So then if that's the case, what you're saying is that if the Fed were to raise rates, let's say two more times in the next few months, let's say their last rate hike ends up coming in, I don't know, November. I forget exactly the schedule of meetings November or December. That the recession wouldn't start then for at least another eight months, which would put us towards the second half of 2024.
Ben Miller:
Correct.
Cardiff Garcia:
I would say though that that's beyond the typical lag of when the yield curve first inverts, where it's something like 12 to 18 months, typically. In that case it would be longer than the usual thing. It would be close to two years, which I think is still within what Campbell Harvey originally theorized. But that's a very long lag from the original yield curve inversion.
Ben Miller:
That's the average. So July 2006 was the peak of interest rates, and it was 18 months from that point to December 2007, and then 2008 was a very bad recession. So that was a long lag. 1980 was only nine months. So it varies, and this one could be shorter than average, but the point that I think I found really shocking to me was, "Oh, my god. If we're nine month lag from December 2023, which is when the Fed says their forecast on peak interest rates is December 2023. We're not even in the first inning yet. The game hasn't even started."
Cardiff Garcia:
Well, in that case, I also feel a little bit better if the recession's not going to actually start until the second half of 2024, then at least we get a little bit more time to enjoy an expansion. Again, though we are playing with some historical averages. And one of the things I would say in response is just that the last few years have been so strange, such outliers in terms of the experience of the economy. In terms of obviously the initial covid, but then the kinds of twists and turns that the economies had to take in terms of supply chain shortages.
And then everything shifted to the goods producing parts of the economy because that's what people were buying, and then the economy reopens and now everybody's all into buying services and not goods. So inflation has been chasing those two parts of the economy. It's all been very strange and all of these sectoral shifts back and forth in the economy.
And on top of that, you have interesting things happening on the supply side in terms of new legislation, working from home. These big interesting odd trends that I think also might contribute to some of these traditional averages and these traditional streaks that we've just been describing in terms of the lag between the end of the rate cycle or the lag from the date of the inversion. All that stuff really might be different. It's why I'm trying to keep an open mind, but it doesn't help somebody in your case, I have to admit, who's trying to arrive at a conviction point of view.
All I'm doing is introducing confusion here, but because I really do think that the economy has been so odd the last couple of years, I think it's important to have that as part of what you've described as scenario planning, consider different scenarios and what could happen because things have been just so baffling.
Ben Miller:
The future is uncertain, but you'd have to believe this time is different.
Cardiff Garcia:
The foremost dangerous words in finance.
Ben Miller:
Correct. And there is a lot to argue that it's worse than average, not better. There's two instances we talked about 100% of recessions have preceded by a rate hike, but there have been two rate hikes where there were no recession. So that's 1964 to '66, they hiked rates by 2.2% and 1994 to 1995, the hike the rate by 3%. So I actually didn't get a chance to find out what was happening in '64, but I know in 1994 that the Berlin Wall had fallen, we had enormous peace dividend, there were a lot of positive world dynamics that basically prevented a recession.
I don't believe that's the case today at all. Not only is this cycle mature, this economic cycle started in 2009, and the reason why it's a cycle is that during an upswing there was these natural excesses, excesses in risk taking, in bad judgment and taking on debt.
And the amount of public and private debt in America today is 95 trillion. That's twice, double, 2007. Which was 47 trillion in the US total public private debt, and that in 2001 was 29 trillion. So it's four X in the last 20 some years. So there's a lot more debt. The natural cycle of winter follows fall and summer, and there's a lot of stuff happening in the world that makes me think there's not likely to be this surprise in the upside.
But the thing, let me just go back to this thing that was shocking for me, for anybody who's sitting in a seat like mine. To imagine that the recession doesn't start until November 2024. Basically we have another year and a half of the current economic environment, and then November 2024, we start a recession. That's not the end, that's the beginning of the recession, and then the recessions are typically six months to a year from there.
So you're talking about two, two and a half years of this environment and worse. And there are just so many principles, borrowers, real estate developers, tech companies, that they can't survive this environment and worse for another two years, three years. That's impossible. The entire market's in denial. That's what the Ford Curve is saying. There's no way that can be the case. Yet historical precedent is close to 100%, as close to a certainty in history as you could ask for. Because you have 100% of recessions started with interest rate hikes. You have a lot of good data around that.
And I think what's happening is that people are fighting that reality so strongly, in such denial, that they aren't recognizing the consequences and that the inevitability of the downturn from interest rates and quantitative tightening, we're not even talking about quantitative tightening, which is a historic novel situation. Interest rate hikes going up and then just basically destroying money, a trillion dollars of money a year. There's just so many things that are on the downside, worse than average, to think that this time is different is just beyond impudent.
Cardiff Garcia:
Yeah. Do you also want to say something, Ben, about how that relates to the very industry that Fundrise seeks to disintermediate, which is private equity? Because when you're talking about business models that may have made sense in a zero rate environment, well those business models don't necessarily make sense in a sustained 5% plus interest rate environment.
And we've already discussed on this very podcast the problem of all these portfolio companies whose valuations just don't make sense anymore. But even beyond that, I suspect that you've got a view on the other implications for private equity of an environment where we're at right now, plus as you described it, this environment and worse. How do you see the effects on the private equity industry, not just private equity as we sometimes think of it, but venture capital and other private investment players?
Ben Miller:
I believe that there are almost no companies that are private that are prepared for a three-year marathon. Whether it's real estate office building, or it's a tech company with overvaluation, or it's a private equity fund that did a buyout that has all this debt coming due, that is not in their business plan. That's why the recession's going to be so much worse than average or it's not going to be a soft landing.
And just to get at the magnitude, so in the nine recessions of history, and I'm going to put aside 2020, which is bizarre, the average decline from peak to trough in the S&P 500 is 43%. 43% is a huge down. The average lag from peak of interest rates to the bottom is 21 months, and we're talking about being maybe a year from the peak. So we're talking about 36 months to bottom, with a almost half of people's net worth being wiped out. That is the average. So that is so much more significant than any possible gain you could achieve by taking risk right now. Risk is absolutely not warranted.
So for us managing our funds, our real estate, we're just... I'm getting even more conservative and I was probably pretty conservative before. So that's why I said that the recessions are the ball game, they're make or break, the 43% down is so much more consequential than the 10% up this year.
The long game is to focus on these huge cataclysmic events that happened, it used to be every 10 years, it seems to be more frequently these days.
Cardiff Garcia:
The US stock market, to stay there for a second, I think peaked sometime around the end of 2021. So despite this year's gains year to date, if the S&P doesn't continue climbing for the next few months or for the second half of the year, you might actually be in a scenario where you get two straight years of the stock market not returning to its prior peak heading into the year where, by your conviction call, you're going to head towards a recession and then another decline. Which means you're talking about, in your case, your base case scenario view would be multiple years before the S&P gets back to where it was in that astonishing and very strange year of 2021. Is that about right?
Ben Miller:
Yeah. The stock market metrics actually tell you that because the price to earnings is approximately 25, more than maybe 26 at this point, that's way above normal or median 16. Whether you're looking at multiples, revenue multiples, or PE, or earnings, or any of the core metrics of the stock market, all of them are still at all time historical highs. So what I'm saying is totally consistent that those would revert to the mean and come down by 20, 30, maybe 40%.
Cardiff Garcia:
Yeah. Also, they're at those highs in an era where interest rates, the short-term interest rate, is now 5%. So the outpacing of the short rate of the dividend yield on the S&P 500, which I think is still, I haven't checked in a while, but I think it's still around 2%. It's quite an astonishing gap at this point.
Ben Miller:
Yeah. You get risk-free 5% and you're going to buy a dividend of two. That's why interest rates, eventually you can fight gravity for so long, eventually run out of gas. You just can't fight gravity forever. And so it's why recessions follow interest rates, hiking cycle.
And then just to give you a sense of the lag, I think the lags is the thing that's just blowing my mind is that usually the Feds actually are already lowering rates before the recession starts. They'll hit a peak. So in '08, '01, 1990, 1974, they had already hit their peak, recognized they'd gone too far and we're lowering it and it was still a recession. So the lag is the biggest thing to recognize. What we'll do is we're going to put out this data, and I have it all over my notes on pieces of paper where we're going to put it out so you can see it, but it's conclusive.
So let's basically look at... Now, let's question this. You say, "Okay, why might this be wrong?" We did some of those things of why this is different, different worse, different better. We did some of the worse, there's still more worse. We haven't mentioned war in Ukraine. We haven't mentioned Cold War in China. Just to make sure we take it off the table. AI, which I think is going to be significant. I think it's going to take three to five more years before its real productivity impact's going to be achieved. We're working on some AI internally, as we play with it, it's really cool. But actually, it's a lot harder to turn into something useful, really useful, not just interesting.
Cardiff Garcia:
And also just worth mentioning, just to jump in real quick, a lot of the things that we looked at in our episode on The Case for Optimism, those are longer term trends. It doesn't mean that there can't be some fluctuations along the way. And when the economy fluctuates down, we call that a recession. That's very, very possible in the context of a longer term upward trend, you do have the occasional big collapse and that's what a recession is. So I don't think things like AI or all the other possible productivity enhancing technologies that we mentioned in that episode and that exist now, are enough that in the short term, they would stave off a downturn in the economy that was due to happen. That increases the long-term potential of the economy. It doesn't assuage the short-term problem when it arises.
Ben Miller:
What you and I are talking about is the cycle and AI and the internet, those aren't cyclical. Those are secular, they're fundamental. And the cycle has natural accumulation of too much debt, too much risk, and then there's a purging, or a winter, and there's a rebirth. And so that's when I have conviction will occur. And I was talking to somebody, who I roof test things with and he said, "How can that be the case? Employment's so strong, economy's so strong, just doesn't feel like there's a recession. I can't imagine it."
So I went back, looked at some data, and I've two really fun things. One thing is I've just looked at newspaper articles from basically shortly before the recession in 2000 or 2007, or '01. Here's January 31, this is 60 days before the March 2000 bubble collapses. So this is CNN Money. Okay. "More so than in any other decade, the US economy's on a prosperity tear on its way into a record 107 months of uninterrupted growth. Annual growth is at 4%, unemployment is at generational low. In short, the economy is good." Okay, that's January 31st, 2000. That's right before a recession.
Here's Fortune Magazine, July 2007, which is when actually everything in the financial markets had blown up. The headline is, "The greatest economic boom ever, just how red-hot is the current worldwide expansion." "This is far and away the strongest global economy I've seen in my business lifetime." Says Hank Paulson.
Cardiff Garcia:
Oh.
Ben Miller:
CEO of Goldman Sachs, former US Treasury Secretary. So here's the one in July 23rd, 1981, which is actually after recessions already started, recession starts in July. This is after recession started. New York Times, "Recession Speculation Rejected." Larry speaks, the Deputy White House press secretary said "There's no basis for speculating that we are in a recession."
Cardiff Garcia:
No basis. The recession had already literally begun. That's incredible. It's always fun to go back and look at the quotes that people have, the sheer ignorance in hindsight of the reality of the situation, or in some cases to look, for example, at the IMFs year ahead projections for economic growth in different countries. I can't remember if it was 2006 or 2007, where they were saying that they were looking at multiple years of positive growth in different parts of the world and turned out to be so incredibly bafflingly wrong.
And so you look at that and you think, "God, what are we all, right this very second, missing?" But you're right. One of the lessons you can take from that is that when everybody's saying one thing that doesn't necessarily mean that that's what's going to come to pass. That everybody getting super excited about this week's economic indicators or the economic indicators of the first half of this year, doesn't mean that a recession will be avoided forever.
We're all vulnerable to looking very stupid later on. And hopefully people won't look at some of our podcasts from the past year and think, "God. Look at those two guys and what they were saying versus what actually ended up happening." But one of the things that I've enjoyed about these chats is that I think we have done a good job of being capacious, of being open to a variety of eventualities. Even as we're trying to arrive at what you've called now a conviction point of view, something that you expect. I think we've also tried to consider the things that otherwise could happen.
Ben Miller:
Let me just add this because I did also look at some research around unemployment because this argument that low unemployment basically forestalls a recession. I wanted to go examine that, and so I gave you headlines, but here, let me just give you the data. Going back to 1970, because I only went back to 1970, I didn't have that much time to do this.
The average unemployment increases by 3.37% when a recession hits. Unemployment is 3.7%, but it was 3.9% in the year 2000. In July 2007, it was 4.7%. So it's often been this low. It is low, but it's not a singular event. If it went up on average, 3.37% unemployment would be at 7.27% at the end of the recession. So if we have an average recession with average unemployment increase, 4.5 million people would be put out of work. So no, low unemployment does not prevent a recession. It's actually par for the course.
Cardiff Garcia:
And in fact, the labor market is the one thing that I'm going to really be looking at in the second half of the year. Because you're right, unemployment, low unemployment doesn't prevent a recession, but when it starts climbing, it can be one of the coincident indicators that a recession has started. I'm going to be looking at the unemployment rate, but I'm also looking at some signs in the labor market that might suggest that things are already softening a little bit.
Nominal wage growth has moderated, we've seen that job openings have been coming down and now initial weekly jobless claims have also, the four-week average, has also been climbing. So there's all these different labor market indicators besides the unemployment rate that we can look to to see if things have started to soften. And I'm already paying attention to those.
In our closing minutes, Ben, do you also just want to take a moment to maybe speak to Fundrise investors who I think are going to be curious about what you said earlier when you said that you're becoming more conservative now, possibly with the anticipation that you'll be able to deploy money, to invest money, once certain things become more attractive, once valuations of certain things come down.
Do you want to just give some sense of how you plan to take advantage of the environment that you're predicting over the course of the next year or so?
Ben Miller:
Most important thing when you're managing people's money is to not lose money. And I don't mean a few percent. I'm talking about what I think is going to happen, a recession, which is huge amounts of money, 20, 30, 40%. And that's my number one concern, is to position the portfolio defensively. And according to this data, according to basically what's the pattern, there's a lag interest rates. The lag basically is likely to mean we're in a recession, not till late 2024, early 2025. And that's going to cause a huge decline. And our job basically is to shield our investors from that.
So I'm much more focused on protecting the downside than trying to capture that [inaudible 00:59:15] on the upside. I think that comes later. Along the edges, of course, we're really active in private credit. You can be a lender today at very high rates. You can make almost double-digit yields at risk that is, I think, very well worth it. Even with a recession in mind. And I think some of the tech market, as we said the tech market is a long-term permanent revolution. There's real innovation happening.
And so you can soldier through some of those things in the short term to capture the upside. If you could own one of the great AI companies, we wouldn't worry about the recession. You just would want to own it. So there are definitely exceptions, but the point I'm trying to make is that to win the ball game is the goal. And that is basically we're just now talking about getting onto the field in the fall with the peak of interest rates as nine innings or nine months from there. And that's basically my perspective. I could see some people being frustrated by that in the short term because a lot of our investors, what's happening in the last quarter. So that's not what I worry about. This is what I worry about.
Cardiff Garcia:
The longer term, the big things that affect the longer term returns in the money you invest. But we should start wrapping things up, Ben. Any other things you want to share with our listeners? Any other things you want to tease from the upcoming mid-year newsletter?
Ben Miller:
It's difficult, I think, to do planning around something that's this far away to say that the market likely to break, at least on historical averages, not till November 2024, and the bottom of the recession would be mid 2025. In some ways, people don't know what to do with that and they're almost likely to put it aside and say, "Well, it's too far away for me to plan around." These big things you can only get ahead of, you can't deal with it at the moment. You have to have done it beforehand. You have to take the hard preventative decisions that are not that fun in the short run.
And there's a famous investor, Jeremy Grantham, from GMO, I love that investor. He was a bear on the tech bubble in '97, '98, '99. And at that time, I think Nasdaq went from 1500 to 8,000, just to give you a sense of how much it went up. And his investors were pounding on his door to basically allocate to tech. And at some point he stopped doing it and reversed out of it because he said it was a bubble and he lost half his investors, 50% of his business disappeared because he would not invest into the tech bubble.
And then in 2001, it proved to be correct, NASDAQ went down 78% from its peak. The entire NASDAQ went down almost 80%. So he was very right, but he was punished for it in the short run. And I basically am saying, I'm willing to be punished on this one. It's not as significant as NASDAQ. It's going to be a really painful experience.
Cardiff Garcia:
I think that's a good place to wrap up. Except to say that I hope people listen to our last two episodes together in conjunction so that they don't get irrational exuberance as the old phrase goes from our optimism episode. And so that when they listen to this episode, they also don't get too bummed out. So you got to listen to them both simultaneously, I think is the recommendation. Ben, always a pleasure, man.
Ben Miller:
Yeah, thanks a lot, Cardiff.
Cardiff Garcia:
You've been listening to Onward, the Fundrise podcast featuring Ben Miller, CEO of Fundrise. My name is Cardiff Garcia, of Bazaar Audio. We invite you again to please send your comments and questions to onward@fundrise.com. And if you like what you heard, rate and review us on Apple Podcasts and be sure to follow us wherever you listen to podcasts.
Finally, for more information on Fundrise sponsored investment products, including all relevant legal disclaimers, check out our show notes. This podcast was produced by the Podcast Consultant. Thanks so much for listening, and we'll see you at the next episode.
