Opinions on the US economy and its trajectory run rampant – even economists can often find it difficult to come to a consensus. However, whilst judgement and opinion can play a crucial role in analysis, prediction informed by economic trends will always trump gut feeling. It’s quite like when your grandpa says he was the most handsome man in Melbourne – sure, it might be true, but there’s no way of proving it without a time machine. Although your grandpa won’t be able to relive his past, the economy has been repeating cycles throughout history, and luckily for us, we can easily identify recurring warning signs of a crash.
The first offender is also the most infamous – the flattening yield curve, a phenomenon where the yield of short-term bonds approaches long-term bond yields. In stable economic conditions, it is expected that long-term bond yields would exceed short-term bond yields, due to the additional time risk associated with them. A classic signal that US cyclical momentum has peaked, a flattening yield curve has historically preceded recessions. The spread between the 10-year and two-year US treasury bond yield is in its lowest level since June 2007, almost flat. In the short run, bond yields are mostly controlled by the fed, who have been increasing short term rates. In the long run, it’s all supply and demand – investors seem to have low optimism in the future economy, and as a result, are moving away from long term bonds.
These twin offenders are more discrete, yet lethal. As discovered during the GFC, the exposure to high-yield junk bonds in US corporate debt can have destructive consequences. US BBB bonds have risen from 33% of total US investment-grade corporate bonds at the end of 2008, to 51% at the end of last year. Furthermore, US BBB-rated corporate bond spreads have risen by 61 bps since early October. Lowering quality of bonds and diminishing investor optimism in the economy can be seen as factors that have forced an increase in premiums in order to continue attracting investors. As a result, the bond market develops a higher overall probability of default – a risk that can create havoc in an economic environment which already holds little optimism for the future.
The third offender is the leveraged loan market. Total leveraged finance has more than doubled since the GFC, growing from $1.2tn in 2008 to $2.79tn at end of 2018. Within this total, aggregate leveraged loans rose from $0.62tn at 2011 to $1.2tn 2018. It’s not just the fact that there is a lot of leverage in the market – many of these loans are taken by low-rated companies who already have too much leverage in their system. Last year, a third of the loans issued were to borrowers whose debt exceed the risk threshold proposed by the US Treasury five years ago. But that’s not all. Despite ongoing fed tightening, 77% of leveraged loans are currently classified as ‘covenant-lite’ loans, which means there are less restrictions for borrowers and less protection for lenders. Investors are willing to accept weaker protection in credit, which could have dire consequences for the economy when borrowers begin to default.
US non-financial sector corporate debt is a measurement of aggregate debt owed by corporations that are not in the financial sector, such as households and government agencies. As a percentage of GDP, it has risen from 39.7% at the end of 2010 to 46.4% at the end of 2018. This has surpassed previous highs from the early 2000s as well as 2008/09- periods which directly coincide with large global recessions. The fact that the non-financial sector is more leveraged than ever makes it more sensitive, and therefore vulnerable, to rising interest rates. We can see this vulnerability through the declining performance of interest rate sensitive sectors such as housing (decline in home sales and residential investment) and autos (decline in US light vehicle sales growth), which coincide with recent quantitative tightening.
When the federal reserve applied quantitative easing to pump money into the economy and counter the 2008 financial crisis, the prices of assets soared. We expect quantitative tightening to do the exact opposite. Quantitative tightening occurs when the federal reserve lets bond holdings mature without replacing them, or in other words, shrinks the supply of money in the financial system. As recent Federal Reserve quantitative tightening kicked in, the balance sheet contracted by US$373bn in 2018. How does this affect us? The reduced liquidity creates a reverse wealth effect – as assets decrease in prices, people feel like they have less, and are therefore more likely to save rather than spend. To illustrate this, let’s say Emily and Sam have the same salary, but unlike Sam, Emily has a $2 million house which is now worth $1.5 million. Although both make the same amount every year, Emily will feel a loss in her net wealth, and will therefore be more likely to spend less, slowing down economic growth.
Last but certainly not least, the number one expense for businesses – hourly wages. When unemployment levels are low, increased competition forces businesses to pay higher wages in order to compete for more qualified workers. As a result, expenses increase, growth slows down, and in the long run jobs are eventually cut. In the last year, we have seen a steady increase in average hourly earnings, rising to highs only previously reached in the GFC. It is crucial to note that wage pressure is also a coincidental indicator of inflation, and along with an increasing velocity of money signals that inflation is (and is projected to be) on the rise.
These six serial offenders, unlike your grandpa’s looks, re-appear throughout history as indicators of numerous previous recessions. As the federal reserve pursues quantitative tightening, the consequential reduction in asset prices creates a reverse wealth effect, causing a decrease in consumer spending. Add high levels of debt distress, tightening credit markets and rising interest rates, we find a recipe for disaster. Companies with too much debt start facing wage expenses and slowdown in growth as they focus on paying off their debt. The dynamic of slow economic growth and rising inflation – as indicated in correlation with rising wage pressure and velocity of money – increasingly forms the basis for an economy moving towards stagflation. The timing of a potential recession is widely discussed and up to personal judgement – will it be this year? Next year? No one knows for sure. What we do know however, is the rising involvement of historical offenders and the consequences that ensue, which will help us determine how risk averse we need to be when making decisions in the years, or months, to come.
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
