Why US Recession Risk Just Dropped to Zero — Eric Basmajian

[00:00:00] Speaker 1: Yeah, sure. So maybe it would be helpful just to kind of reset the clock back to the pandemic. So, of course, we were, you know, heading into the pandemic around 2019. The pandemic occurred. We had this massive amount of stimulus that occurred through 2021 and 2022. Interest rates stayed very low. And, you know, for 2020, 2021 and 2022, it was, you know, a very extraordinary economic boom fueled by a lot of stimulus money that was going around. Then what happened is the Federal Reserve, you know, got the wave of inflation and they had to begin raising rates and tightening policy in 2022. And pretty quickly, they raised rates 500 basis points. And what happened at that point, so when the Federal Reserve tightens monetary policy, for the guests that may not be familiar, what we do is we forecast business cycles for the purpose of forecasting the risk of recession over six to 12 months. Because for investors, asset prices generally tend to trend higher over time. And then there's periods of nastiness, you could say that just cluster around recessionary periods. That's why forecasting recessions or spotting recessions is attractive thing to do for investors because absent a recession, markets and assets tend to trend up, it's really only the recessions that cause the significant impairments of capital. So when we look at forecasting recessionary periods, they follow a very sequential sequence, kind of every single business cycle that we have data for follows the same process. They have a little bit of nuances here and there, but predominantly, a tightening of monetary policy leads to a slowdown in early ticket, or early, what we would call leading indicators, things like building permits, the transaction volume of housing. So new home sales, existing home sales, that slowing of demand compresses the margins of residential home builders for the most part. When residential home builders start to see their margins compress, they're forced to lay off construction crews. And then it's the early job loss in the construction and manufacturing sectors that create the downstream economic stress. So what happened was after the Fed raised rates, as you would expect, we got the decline in building permits, we got the decline in new home sales, we got everything that started to happen, and we got the decline in builder profit margins. So what we're looking at here is on the left home builder profit margins, this is aggregated from the top 15 publicly traded home builders. So you could see that going into the pandemic profit margins were very stable around 10%. We had this big surge up to 20% of the pandemic and right when the Federal Reserve started tightening monetary policy, you had the profit margins compress exactly like you would expect. So now at this point in the process, we were expecting as a result of the big decline in building permits, the big decline in new home sales, the tightening of policy and what was the beginning of the decline in builder profit margins that builders would begin to lay off employees. We saw increases, we saw increases very small increases in initial jobless claims, and should the builders have commenced larger scale layoffs, it probably would have cascaded towards the normal recessionary process. But what happened is you could see in the chart is that the profit margins were so elevated, the highest level we've ever seen, that they went down 1000 basis points from 20% to 10%. And at 10% today, we're still at the same level that we were before the pandemic. So builders have trimmed crews, they stopped hiring and they've done some things around the edges, but they never were forced to commence larger scale layoffs as they would have in the past. So if you had builders had margins go down 10% from basically any other point in history, they would have been from 10 to zero and you would have had larger layoffs. Now, pressure is still existing in the housing sector because of the building, we're talking residential construction on home prices, because the margins are still falling. But what's happened in the other parts of the economy is the Fed started to cut interest rates, and we started to see an acceleration in other areas, rather related to AI. [00:04:38] Speaker 2: Just note the time here when when what period are you talking about now? [00:04:43] Speaker 1: So so at the end of 2025. So at the end of 2025, the Fed was cutting rates in 24. So towards the end of 25, we started to see a cyclical upturn in construction and manufacturing employment. Offsetting the weakness that we were seeing in residential, I mean, it was very small declines in residential employment, not very big. So the AI spending started to kick in, you had an increase in non residential construction jobs, you had multiplier effects through manufacturing, and then you started to get an upturn in other area parts of the economy cyclical parts of the economy. So where we stand today is a labor market that has improved for basically everywhere except housing. But housing, the declines are just very, very, very small. So the other parts of the economy are starting to accelerate. And that's causing a retightening of the labor market. And when the labor market tightens, that's puts recession risk pretty close to zero. So at the moment we have increasing construction and manufacturing employment, which makes recession risk low. So the negativity that we had on the economy was based on the sequence playing out. And what ended up happening with the benefit of hindsight was the margins were so high they were insulated or they were able to kind of cushion this multi year downturn without commencing the larger scale layoffs that normally would have triggered a larger recessionary cascade. [00:06:06] Speaker 2: Okay, some people are audio only. So I just want to explain what we're seeing. So there's two charts Eric is showing one is home builder profit margins are falling is the title. And it shows, you know, that they're lower than before. And then corporate profits rise as a share of national income. Do you want to talk any more about the corporate share side? [00:06:27] Speaker 1: So on the on the on the on the right side of the chart, we're looking at economy wide profit margins. So this is for every public and private corporation. And the reason we're looking at this one is because the ultimate sort of leading indicator or driver of recessions, as I mentioned, is that whole sequence I outlined for the home builders or residential plays out for the broader economy, but it plays out first in the housing sector because of the interest rate sensitivity. So when you have declines in home builder margins, and then that leads to job losses in residential construction, those people who become unemployed put stress on the rest of the economy and compress the rest of the economy's profit margins, and then it's like a series of dominoes. [00:07:13] Speaker 2: Right. One thing, though, you keep talking about home builders, and I appreciate that because, you know, we're talking about real estate, right? Mostly, of course, the broader economy is important, too. But home construction compared to the overall economy is a pretty small part of the overall economy. So it kind of surprises me. It just kind of feels like you're making a leap from construction workers, which there's a shortage of. Right. But, you know, if they get laid off, that's going to cause a recession. Isn't that a bit of a leap because compared to the overall economy, that's pretty small part, right? [00:07:48] Speaker 1: Yeah, I'm glad you mentioned that. So construction and manufacturing together. [00:07:52] Speaker 2: Manufacturing. Yes. Now that's a different story. Yeah, yeah, yeah. Just construction. [00:07:56] Speaker 1: I'll tie it all together. So construction and manufacturing together currently are 21 million jobs, which may surprise me. [00:08:04] Speaker 2: That's significant. It's a pretty big number. So that's going to be of the total jobs, which I think there's about, I don't know. It's about 13 percent. Yeah, 13. Yeah, I was I was going to say 180 million jobs in America or something like that, right? Yeah, about 160, 160 million. Thank you. So there you go. That's your number. 21 percent of 160 million jobs is how much we're talking about. [00:08:28] Speaker 1: OK, there you go. So what what's interesting, though, is that that percentage has fallen over time. So as a percentage of the private sector, it's about 13 percent in the year 2000, which was 26 years ago, it was 17 percent. So it hasn't fallen that much from 2000 until now. So 17, 13. If you go back to every recession when when they were a very much larger share of the labor force to even now when they're just 13 percent, over 100 percent of the recessionary job losses come from construction and manufacturing. So if you have 21 million jobs and you lose 10 percent of the labor force, which would be small because it's such a volatile sector, that's still two million jobs against the rest of the economy, which is more than. [00:09:18] Speaker 2: Was it that was 21 percent or 21 million? [00:09:21] Speaker 1: 21 million. OK, got it. 21 million. So homebuilders of that construction manufacturing, that 21 million residential construction is about three, three and a half. So it is a small subset, but it's the the reason that we focus on that is because it's at the bleeding edge of that 21 million. And there tends to be multiplier effects that go through. So when you build a lot of homes, you need a lot of washing machines and a lot of dryers and a lot of trucking. [00:09:50] Speaker 2: Dishwashers. That creates a manufacturing process. Window blinds. Exactly. [00:09:55] Speaker 1: So there's an interconnectedness between residential and manufacturing. So when you lose jobs in residential, that creates some pressure on manufacturing. And then you start to get to this kind of breaking point, which we've calculated somewhere between 300 to 400,000 job losses in the construction and manufacturing sector. When you hit that level, that's when there's enough kind of accumulated pressure where it creates downstream stress on the rest of the economy. And then that's what pulls down the profit margins in the in the right hand chart, which is total corporate profits. But what you could see is that because the margins were so high, home builders are so profitable in 2022 that we saw the monetary tightening. And we only ended up losing about 150,000 jobs total in construction and manufacturing. So we did lose jobs. The sequence did play out as you would have expected. But instead of getting to that three, four, 500,000 level that would have created a lot of stress, you got to about 160,000. And then AI spending started to come. And that kicked off non-residential. That created a manufacturing process. And those construction and manufacturing payrolls have now turned higher and now have exceeded the peak of the past cyclical upturn. So we now have sort of a rip roaring upturn in those construction and manufacturing sectors, residential still being a little bit of a weak pocket. So because of that, you're not going to get any downstream pressure on the less interest rate sensitive parts of the economy. And thus overall recession risk is quite low. And that generally bodes well for asset prices. [00:11:49] Speaker ?: Thank you.