Now that the first part of the year has finally come to an end, it’s time to accept the trend of the past six months in order to be better equipped for what’s to come.
The signals we are gathering from financial markets are alarming, and we are worried that evidence supporting an imminent recession is piling up even though the global economic backdrop continues to be supportive of equity markets, US inflation is around the Federal Reserve’s 2% target, and unemployment is incredibly low.
The factors that lead us to believe a recession is coming, however, are as follows:
Financial markets are overleveraged. In the US, nonfinancial corporate debt stands at 30% of GDP, an all-time high and a figure whose growth comes thanks to the Fed’s ‘taper tantrum’ of the past few years. With interest rates kept at historic lows for a decade, credit conditions have become incredibly lax and lenders have been pushed to agree to lower interest payments and issue covenant-lite loans to be able to participate in the credit market.
Now that the Fed is tightening policy and there is $10 trillion in debt set to mature in the next five years, it becomes clear that as interest rates rise, refinancing is going to become increasingly more difficult.
There is a risk of overtightening from an incredibly hawkish Fed. This risk emerged as Jerome Powell took the reins and indicated that the Fed is getting ready to hike twice this year and four times in 2019. Again, this will hit overleveraged companies first as they will be unable to refinance their debt at convenient interest rates. This could also produce a liquidity squeeze in emerging markets as the US dollar continues to be strong and the value of their foreign exchange reserves diminishes. Already this year we have seen Argentina, Turkey, Bahrain, and other EM countries ensure currency crises, and as market conditions become tighter, it might be difficult to contain these events within isolated volatility episodes, as they can easily trigger a selloff within the bond space.
The more we review these potential causes of distress, the more we realise that the effects of a recession would be completely different from the ones seen 10 years ago.
While the crisis of 2008 centred on the stability of the financial sector, a recession today would not place banks in a similarly difficult place as the rules of the game have changed since the financial crisis. Banks worldwide now have to comply to strict stress tests which aim to keep them well capitalised and able to absorb market shocks. Traders’ books have been shrinking, but banks have been managing their books efficiently, allocating investment in strategic corporate loans.
Although banking regulations and requirements appear to have successfully cleaned the system of dangerous investments, however, data suggest that overall leverage has increased since 2008.
If banks aren’t holding that risk, who is?
The short answer is real money investors. Loose monetary policy in the US, Europe, and Japan has unwittingly pushed investors towards riskier assets as lower interest rates spurred risk appetite. Investors who previously stuck with bonds are now active in equities and may even be willing to take on leverage and participate in the volatile FX market.
If a credit-driven burst happens now, the pain will be felt most directly by real money investors.
Although quantitative easing was used to heal a system that had become unsustainable, its side effects may yet prove more harmful than the disease. One of the most obvious such effects can be seen in how low borrowing costs have pushed companies and governments to borrow ever-increasing sums without considering that the easy money would one stay stop flowing. Now that the Fed is tightening and financing conditions have changed, a credit-driven recession is likely.
This week’s FOMC minutes will be closely watched as many market participants are fearful of an inverted yield curve and believe that, as stress in the credit market intensifies, the only solution will be for Powell to slow down and reconsider the hiking path outlined last month.
The good news is that a recession is not likely until 2020. We are still in the so-called late economic cycle and there remain good opportunities out there; we do not yet see a need for turning defensive and jumping into typical capital-preservation trades.