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Bridgewater ®

Daily Observations
November 17, 2022 ©2022 Bridgewater Associates, LP

(203) 226-3030 Greg Jensen

Rob Hurn
Nina Lozinski
Thinking Through the Challenges of the Next Recession
Just as inflation was the story of 2021-22, we believe growth weakness will be the story of 2023.
We are wrestling with whether we are missing anything with respect to how long and how deep the coming
slowdown will be. Markets are expecting a modest downturn that allows the Fed to stop the tightening cycle, but
with very little damage to the economy or profits. As with everything we do, we build out systematic estimates for
growth and earnings that reflect all that we have learned about the cause/effect linkages that drive them. On net,
we believe that we are on the precipice of a big recession and that markets are not appropriately discounting
this risk. However, we are constantly trying to look for what our systems might be missing. There are cross-cutting
factors that support the argument for a more moderate slowdown. In these Observations, we summarize the
arguments we see on both sides and walk through how we are netting these to form our view.

The primary arguments in favor of the modest recession/soft landing theory are:

1) Private sector balance sheets came out of the COVID recession significantly better than they entered it
because of the size and the nature of the fiscal stimulus.
2) The long period of easy money allowed private sector debtors to significantly extend the duration of
their debts, making most borrowers less exposed to short-term tightening and rollover risk.
3) High inflation is a potential cushion in a downturn because income growth can remain positive even if
real growth is negative, which makes it easier to meet rising debt service costs.
4) Banking reforms post-2008 have significantly mitigated the risk of financial contagion.
5) Businesses and governments around the world are likely to be forced to spend acyclically to deal with
deglobalization, the energy crisis, rebuilding defense industries in Europe and Japan, and climate change
concerns.
6) The power of fiscal policy is now so clear that many Western economies may react to the next recession
with significant fiscal stimulus and checks to households.
On the other hand, the arguments for a longer and deeper recession than markets anticipate are:

1) Policy makers are more constrained by inflation than at any time since the early ’80s, which means they
will tighten much further into the downturn and ease much later than what we have seen in more recent
recessions.
2) Already, the tightening that has occurred is far larger than any in the last 40 years.
3) Private sector balance sheets are healthier than pre-COVID or pre-GFC, but…
a. This balance sheet health is rapidly declining, and household savings rates appear
unsustainably low.
b. The world is still highly levered.
c. Many borrowers across the world are seeing debt payments rise in ways they have not seen in
decades.
4) Even if the private sector proves more resilient than we expect, the Fed will be forced to tighten until the
labor market softens enough to break the wage-price spiral. Getting the crack in the labor market will
require much weaker profits.
5) The possibility of a divided government in the US combined with budget pressures from ballooning
interest expenses decreases the likelihood of significant fiscal stimulus to support growth.

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All the points above are accurate, but as we net the pros against the cons, we measure the cons to be much larger.
In our view, it is likely that the coming recession will prove to be longer and/or deeper than markets are currently
expecting. Below, we walk through these linkages in more detail.

Policy Makers Are the Most Constrained They Have Been in Decades, and as a Result Are Lagging the Downturn
in Markets and the Economy

For the first time in decades, policy makers face a material trade-off between preserving growth and bringing down
inflation. The net is that we expect that they will continue tightening much longer and will shift to easing much
later than we are used to. Already this dynamic is emerging. In the past few cycles, current conditions of growth
slowing rapidly and equities down ~20% on the year would have been enough for the Fed to have already shifted
to easing. Today, however, the best those looking for a pivot can hope for is a shift down in the rate of increases.
The result is likely to be longer and deeper recessions than what we have experienced in recent decades. As the
chart below shows, three of the last four recessions lasted only a handful of months, in part because the Fed pivoted
to easing at the first sign of weakness. In the ’70s and ’80s, when the Fed faced more significant constraints, it
often waited until growth was much weaker, and, consequently, recessions tended to be more severe.

US Real Growth
Recessions Potential Fed Starts Easing Fwd Est
1 8%
0.9
6%
0.8

The Fed would usually After the Fed does

0.7 4%
already be easing by start easing, growth
now; prior recessions 0.6 doesn’t usually
2%
where inflation was a 0.5
bottom for several
constraint for the Fed months; today, the
0%
were typically longer 0.4
Fed has yet to
and deeper pause tightening
0.3
-2%
0.2

-4%
0.1

0 -6%
1960 1970 1980 1990 2000 2010 2020
Length of Recession
(Months): 10 11 16 22 8 8 18 2

Constrained policy makers increase the odds of long and deep drawdowns for assets. The chart below shows
drawdowns in the US equity market relative to when the Fed pivoted to easing. Nearly every time equities have
been down as much as they are today, the Fed would already have been easing. As we’ve written about in previous
Observations, equity bear markets usually don’t bottom until policy makers ease.

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US Equity Drawdowns Worse Than 10%

During Fed Easing
0%
-5%
-10%
You have to go back
to the inflationary -15%
’70s to find the last -20%
time equities fell this
much without the Fed -25%
pivoting to easing -30%
-35%
-40%
-45%
-50%
1960 1970 1980 1990 2000 2010 2020

The Tightening That Has Already Occurred Is the Largest Since Volcker

In the absence of a shift to easier policy, it’s hard to overstate how large the tightening has been. The charts below
show how this is the fastest tightening we have seen since the Volcker era. We have already seen some of the
impact of this tightening in the most rate-sensitive areas of the economy, such as housing, and we expect the
broader impact will continue to flow through with a lag. So far, the economy has proved relatively resilient to this
tightening, in large part because households have continued to dissave despite rising rates. This type of tightening
has been devastating to economic growth anytime it has occurred in the past.

Fastest increase since

Fastest increase ever
Volcker

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The Private Sector Can Only Net Dissave for So Long. We Are Now Reaching the Limits of What Is Sustainable.

The health in household balance sheets that was created during COVID has enabled the private sector to continue
to borrow and dissave, providing a boost to growth above the increase in incomes. As you can see on the charts
below, household borrowing remains robust, and households are still saving at the lowest rate in decades. We
don’t think this is sustainable. Household wealth is deteriorating fast given the sell-off in asset markets, and the
incentives to save versus spend are reversing quickly given rising interest rates and deteriorating asset prices.

Strong Balance Sheets Have Supported Continued Household Borrowing and Dissaving into 2022…

Strong balance sheets Household balance

have continued to sheets are healthier
support household than at any time
borrowing and dissaving since the financial
into 2022, but this is crisis but are starting
likely to reverse rapidly to deteriorate

…but the Incentives to Borrow and Spend vs the Incentives to Save Are Rapidly Reversing

Higher Falling asset

interest rates prices both have
increase the a negative wealth
attractiveness effect and reduce
of saving and collateral for
decrease the households to
attractiveness borrow against
of borrowing

Private Sector Debt Levels Are Lower Than Recent Cycles but Still Elevated; Higher Interest Rates Will Eventually
Begin to Bite

One dynamic supporting a softer recession today is that many players took advantage of the years of lower rates
to term out their debt and lock in low rates. However, there is still plenty of private sector leverage. Even with a
somewhat less rate-sensitive economy, the extremely fast rise in rates will drive a pretty rapid rise in debt service
costs. So far, the drag from larger interest payments has been partially offset by rising incomes. But if incomes fall,
this will become an increasing drag.

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Household debt Household

levels lower than interest expense
pre-COVID and relative to
pre-GFC but still incomes is
elevated relative growing fast
to history

Corporate debt
Corporate debt burdens are low, but
levels high in higher interest rates
absolute terms will eventually start
but about average to bite; continued
relative to the slowing of earnings
strength of earnings growth would be
a further drag

In Order to Bring Inflation Down, the Fed Will Have to Tighten Enough to Crack Profits and Break the Wage-
Price Spiral

Eventually, we expect we will need to see a crack in wage growth and employment in order to bring inflation down.
Wages are unlikely to crack unless businesses face a hit to profits, so ultimately bringing inflation down will require
the Fed to tighten until we get a sufficiently large contraction in corporate earnings. Without being overly precise,
we estimate that an approximately -20% hit to profits is what is needed.

Slowing inflation …which usually

would typically take takes a significant
an approximately contraction in profits
3% increase in before businesses
unemployment… reduce their
demand for labor

Amount of inflation reduction needed

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This Environment Poses Acute Risk to Assets and Raises the Likelihood for a Prolonged Period of Weakness

All in all, we see the pressures today lining up for a longer and deeper recession than markets expect, likely leading
to a longer and deeper drawdown in assets. The table below shows all the cases over the last ~60 years in the
developed world where a traditional 60/40 portfolio experienced a prolonged drawdown (charts of these cases
are included in the Appendix). The common thread across many of them was that policy makers were unable or
unwilling to adequately stimulate the economy. In several cases, elevated asset valuations worsened the picture
for asset holders. Today, both of these dynamics—constrained policy makers and elevated valuations—are
present. As we’ve written about in previous Observations, today assets do not appear to be pricing in the likelihood
of material economic weakness.

60/40 Portfolio Real Drawdowns Longer Than 5 Years, Dev World Since 1960
Country Start Length Policy Response Asset Valuations
The most
dangerous periods Japan 1990 17 Years Insufficient Stimulus Very High
for assets are Europe 1969 14 Years Constrained by Inflation Moderately High
when valuations
get stretched and UK 1972 12 Years Constrained by Inflation Moderately High
policy makers are
Japan 1973 11 Years Constrained by Inflation Moderately High
unwilling/unable
to stimulate during US 1973 10 Years Constrained by Inflation Moderately High
the downturn;
both risks are
Europe 2000 6 Years Minimally Constrained Very High
present today Europe 1962 6 Years Moderately Constrained Moderately High
US 2000 6 Years Minimally Constrained Very High
Europe 2007 6 Years Insufficient Stimulus Average
Japan 2007 6 Years Insufficient Stimulus Average

Stepping back, we think the balance of odds today is tilted toward a prolonged period of weakness in assets and
the economy. This is not discounted and will likely be the major story of 2023.

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Appendix

60/40 Portfolio Real Return Drawdowns

US Europe
0% 0%

-10% -10%

-20% 6 years -20%

6 years
6 years 6 years
-30% -30%
14 years
10 years
-40% -40%
1960 1970 1980 1990 2000 2010 2020 1960 1970 1980 1990 2000 2010 2020

UK Japan
0% 0%

-10% -10%

-20%
-20%
-30%
6 years -30%
-40%
-40%
-50%
12 years 17 years
11 years
-60% -50%
1960 1970 1980 1990 2000 2010 2020 1960 1970 1980 1990 2000 2010 2020

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