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Economist David Rosenberg has been warning for years that the U.S. economy isn’t as healthy as it might seem. He has a history of bucking conventional wisdom. The longtime bond bull spent seven years as Merrill Lynch’s chief North American economist, where he picked up on signs of a deteriorating economy before many others did. In 2005, he warned about the U.S. housing bubble, a year before it began to burst, and he called the last recession well before his contemporaries did. In 2009, he moved to Toronto-based wealth manager Gluskin Sheff & Associates, serving as chief economist and maintaining his bearish outlook for much of one of the longest bull market in history.

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Now, a decade after his move, the 59-year-old self-described contrarian is as bearish as ever. Barron’s caught up with Rosenberg, who recently set off on his own as chief economist and strategist at Rosenberg Research & Associates. He remains a bond fan, predicting that another recession and stretch of disinflation—if not deflation—are around the corner. His against-the-grain recommendations go beyond bonds to gold to drug retailers to oil and gas. An edited version of our conversation follows.

Barron’s: What is your outlook for 2020 and beyond?

David Rosenberg: The consumer has no doubt surprised me in terms of its resilience. But as the legendary economist Herb Stein famously said, anything that can’t last forever won’t, and the consumer-resilience narrative is looking pretty stale to me right now. I expect that the consumer will lose its resilience this year. The pace of job creation is likely to slow, and, along with that, personal income growth will moderate. There is no recession without the consumer playing a part, and there are some early detection signs that the consumer this year will not be what the consumer was last year.

Will that cause deflation?

In the next 12 to 24 months, we’re going to be talking more about deflation than we have any other time this cycle. That’s something, by the way, that the Treasury market has already started to sniff out. You see that with the long bond yield having just broken back below 2%. I see the 10-year yield breaking below 1% and the long bond below 1.5% in the next one to two years.

You’ve been bullish on bonds for a long time. What is the Treasury market saying?

The Treasury market is saying that the shift I’m talking about, in terms of falling consumer demand, is already taking place. The Treasury market is actually a better leading indicator than the equity market.

Why are Treasuries a better economic indicator than stocks?

I find it amazing that so many analysts and strategists look at year-over-year inflation. You really have to focus on inflation expectations, which look forward and help capture how perception affects reality. The small-business survey conducted by the National Federation of Independent Business shows that a record-low number of small businesses say inflation is their top concern. And when you go to the University of Michigan’s consumer sentiment survey, you see the median inflation expectations are at their lowest level in recorded history.

So here you have the people who set the prices—businesses—and the people who pay the prices—households—saying something very consistent. Inflation expectations are at historically low levels, which is rather incredible when you think about it in the context of the tightest labor market in 50 years and an equity market that is at all-time highs, heading into the 11th year of an economic expansion. Treasury yields are reflecting this dynamic in a way that the stock market is not.

Do you think this threat of disinflation or deflation over the course of the next couple of years is something the stock market is missing?

Well, what has made this cycle unique is that the correlation between gross-domestic-product growth and the direction of the S&P 500 index has only been 7%. Historically, it has been 30% to 70%. The stock market is telling you nothing about the economy anymore. Economic fundamentals have never mattered as little for the stock market as has been the case during this 11-year bull market. The stock market is behaving more like a commodity than anything else, in that it’s trading on simple supply and demand.

Why has that relationship broken down?

It’s perfect symmetry. We have had $4 trillion of quantitative easing matched perfectly by $4 trillion of corporate share buybacks, to the point where the share count of the S&P 500 is down to its lowest point in two decades. You would normally believe that a powerful bull market in equities would have been reliant on a strong economic backdrop. But that’s far from the case. We have never before seen such a stock-market performance in the face of what has been in the last 11 years the weakest economic expansion of all time. We haven’t even had one year of 3% or better real GDP growth in the U.S. since 2005.

How has this long bull market for stocks happened amid lackluster economic growth?

Share buybacks are the way you square that circle. That has been a major source of demand, which has nothing to do with the economy and is giving an illusion of prosperity. In a very counterintuitive sense, the reason the correlation between the economy and the stock market has broken down during this cycle is because the stock market has actually needed to have the economy weak. What has happened in this cycle is that companies that issued massive amounts of debt did not use the proceeds to finance capital expenditures and instead repurchased shares, inflating earnings per share. That’s how we managed to take sour cream and make it into ice cream.

At what point does the breakdown you describe in the stock market versus the real economy catch up with investors?

Arithmetically it has made perfect sense to borrow money and buy back your stock, when you look at the relative yields in the corporate bond market and the yields in the stock market. But that relationship may soon come to an end. We’re starting to see some pivot here in the yield relationship that could start to affect the buyback cycle.

Going back to the idea that this may be the year where the U.S. consumer loses its resilience, the most dangerous thing anybody could do is extrapolate the strength in the job market over recent years into 2020 and beyond. Corporate profits have shrunk for three straight quarters and look to be about flat for the end of 2019, and that will feed through to the household sector. From October to January, there was practically no growth in inflation-adjusted retail sales. Where U.S. consumer demand goes, the rest of the world is going to follow.

What are the signs that the U.S. consumer is weakening?

We’re already starting to see signs of wage growth subsiding, in the context of a labor market that still appears to be quite tight. But the truth is always in the price. If this was truly a vibrant labor market, wage growth would be accelerating at this point—not showing signs of deceleration. On top of that, a broader unemployment rate—which includes discouraged job seekers and part-timers seeking full-time work—has bottomed and is starting to hook up. A lot of people are making a big deal out of the rise we’re seeing in the labor-force participation rate, but this is not the same sort of increase you see early in an expansion, when we’re drawing in recently unemployed skilled workers. The principal source of this participation increase is really coming from unskilled workers going into low-valued-added, low-productivity sectors of the economy, like retail and customer service.

How do you see the 2020 election playing out?

There’s a general belief that Donald Trump is going to win, and he probably will. But there is a nontrivial chance that Bernie Sanders does emerge as the Democratic candidate, and there is a nontrivial chance—about 40%—that he could be the next president.

Will the Federal Reserve cut interest rates this year? Will we ever return to more “normal” rates?

We already have that answer. During his confirmation hearing, Federal Reserve Chairman Jerome Powell said it was time to start normalizing interest rates. One of the first things he did was raise the estimate of the so-called neutral federal-funds rate to 3% from 2.5% while suggesting we’d likely have to get above that. Who would know that they’d never get to neutral? You have to go back to the 1930s to find the last time the Fed got stopped out at such a low fed-funds rate.

Why did the Fed reverse course on normalizing interest rates?

To think that all it took was a 2.5% fed-funds rate to cause the corporate bond and stock markets to choke in December 2018 is a real testament to how acute the problem is. We are simply choking on too much debt. The economy cannot handle a nominal funds rate above 2.5%, and it can’t handle real [inflation-adjusted] rates much above zero because of the gigantic debt morass. The poster child is the corporate sector, though other measures of debt are high. It’s not just the U.S.—it’s global. Interest rates have no staying power on the upside, and they will come down. The question is the speed and the level at which we bottom out.



Could stocks fall even if the Fed cuts rates?

With the correlation between the economy and the stock market so low, you’re probably better off talking about the stock market with your electrician, your plumber, or a taxi driver. An economist is not going to help you, because the stock market has not been operating on fundamentals. What I do know is that at some point the party ends. Economic forces are still very important to the Treasury market, even if they’re not important to the equity market.

If I’m correct, the yield curve will melt like a snowball in July. Your best strategy is to buy 30-year zero-coupon bonds, which will generate equity-like returns without taking on equity risk. That is my No. 1 recommendation for the next 12 to 24 months. If the long bond can make you 20% total return in 2019, when the S&P 500 made 30%, imagine what the long bond does if we enter into a bear market in equities.

How can we ever get back to “normal” rates?

There are two ways. The first is we have a multidecade period of austerity, or a prolonged debt diet. The second is a large-scale “debt jubilee,” or debt monetization program, by which the U.S. Treasury would put a large sum on the Fed’s balance sheet and the Fed would then print the money. This would be different than QE, where the Fed created excess reserves in order to boost liquidity at banks. It would be a benevolent debt default through hyperinflation.

Are either of these paths—austerity or debt monetization—likely?

Austerity is going to be a bitter pill. I could see debt monetization happening in the next recession, which I see in the next year or two. Things will get so bad that current critics of debt monetization will line up for it, much as was the case with QE. There are no more fiscal hawks—they’ve gone the way of the dodo bird.

Aside from buying long bonds, how else should investors position?

Within the U.S. stock market, the aerospace and defense sector is in a secular bull market, as military budgets are going up everywhere. The global semiconductor industry has almost become a staple within the business spending arena.

I also like gold, because it’s inversely correlated with interest rates and also because I’m noticing central bank after central bank diversify into bullion. Gold is just like bonds, a hedge against this elongated period of trade policy and domestic election uncertainty.

Drug retailing tends to be a reliable place in a recession, where you can still participate in the stock market without getting crushed. My last recommendation is oil and gas, and this is because I’m a contrarian by nature. The oil and gas industry is priced for the whole world turning into the Jetsons, driving electric vehicles in the next five years. I don’t think that’s going to happen. You want to buy sectors that are priced to extinction, and energy can scarcely be cheaper than it is right now.

Where should investors be looking on a geographic basis?

Japan is my favorite turnaround story and has been for a while. Prime Minister Shinzo Abe is the most transformational leader in the world, and his policies have helped revive the growth potential of the Japanese economy. That’s not to mention other changes taking place there from a corporate governance standpoint that is elevating shareholder returns. They are meanwhile permitting work visas for the first time, and more importantly the female labor-force participation rate in Japan is in a bull market. The rate of return on assets has a significant correlation to the female participation rate.

Japan has yet to fully embark on an equity-ownership culture, like the U.S. did in the 1980s. The country is under-owned relative to its own history and to developed markets. Supply-side changes under way, such as easing guidelines around immigrant work visas, in addition to ongoing efforts to increase transparency will help change that. It’s a long-term buy and hold.

Write to Lisa Beilfuss at lisa.beilfuss@barrons.com