Watch the financial cycle: are we headed for recession?

Indicators suggest that something is not right at all

July 08, 2019
The US economic expansion is now the longest on record. Photo: Michael Brochstein/SIPA USA/PA Images
The US economic expansion is now the longest on record. Photo: Michael Brochstein/SIPA USA/PA Images

Sometimes it’s a good thing when economics and finance folk talk a lot about the next recession. Their concerns may temper the sort of exuberant or even reckless behaviour that normally precedes one. This may not be one of those times however.

As of this month, the post-financial crisis expansion has been underway for a decade. In the US, it is the longest since records began in 1854, but it is losing momentum. In Europe, which succumbed to a second crisis in 2011, the expansion is younger but weak. In countries that avoided the financial crisis directly, including Australia, Canada and China, economic growth is flagging. While worries have been widely aired this year, there do not seem to be conventional reasons to expect an imminent end to the expansion.

Note, though, that few recent recessions have been conventional. In the US, only one of the last four recessions has been, that is, triggered by policies designed to tame excess demand and inflation—and that was in 1981/82. The other three had their unique circumstances but were all precipitated by unpredicted financial shocks. An important trigger for the 1990/91 recession was the regulatory and real estate response to the savings and loan crisis. The 2001 recession unfolded in the wake of the bursting of the dot com bubble. The much longer 2008/09 recession was of course down to the crisis over mortgages and leverage.

The next recession is also very likely to have financial origins.

According to the Bank for International Settlements, the central banks’ central bank, on one measure, the global financial cycle (comprising inflation-adjusted credit flows and house prices, and the credit share of GDP) peaked in 2015/16, and started to roll over in 2017 in countries accounting for just over a third of world GDP. These include advanced economies that avoided the financial crisis, China, and emerging market economies, and we can trace slackening demand conditions in these areas directly to this cyclical shift. Non-financial corporate debt in China has started rising again after a brief hiatus, and household debt as a share of disposable income now exceeds that in the US. High corporate debt levels in major emerging markets such as Brazil and Turkey also create vulnerabilities. Rising indebtedness though is now much more likely to be associated with vulnerability than new growth. Brazil, Mexico and Russia—two Brics and another EM darling—will struggle to deliver 1.5-2 per cent growth in 2019.

In countries that were at the heart of the financial crisis, including the US and the UK, the cyclical pattern was different, peaking in 2007, declining steeply until reaching a trough in 2014, and rising again thereafter. While real estate and credit trends have generally not been strong in these countries, there are important potential weaknesses. Corporate debt in the US, for example, has reached new high levels, especially in the so-called leveraged loans sector, in which already highly indebted companies and persons with weak or poor credit histories borrow in high yield markets. In the US, and in some parts of Europe including the UK, equity markets seem relatively buoyant still, but in some cases they are throwing out warning signals with valuations at alarming all time highs save only for the dot com bubble around 2000.

Given the longevity of the expansion, the high valuations of assets and the accumulation of debt, it is all the more curious in a way that in many major countries we can see a) low inflation and the absence of major upward pressure on wages, despite low rates of reported unemployment and b) capital flooding into bond markets, pushing down yields, and in the US, leading to an inverted yield curve where long-term interest rates lie below short term rates. That’s not normal and often, though not always, signals an impending recession. About $12.5trn of investment grade and government bonds in Europe and Japan already carries negative yields, in which owners pay the issuer for the privilege of holding their paper. That’s about a third of the market capitalisation of outstanding global bonds.

Something in all this—a flagging, “lowflation” global economy after 10 years, exceptional valuations for equities and bonds, and a rolling over financial cycle—is not right. At all. Now throw in all the conventional things that talking heads drone on about. So, the US expansion is losing traction, Europe and Japan are weak, and China is slowing with potentially serious problems. The backlash against immigration, the disruption of global supply chains, the US-China trade war impact and much more are all exacting growth costs.

Further, there’s a crisis looming over the World Trade Organisation, where the US block on judicial appointments and upcoming retirements means that by December, there will only be one (inquorate) judge of seven. A rules-based multilateral trade body that can’t enforce its own rules is not only toothless but a symbol of the fracturing of global trade. Throw in the now familiar politics of populism and nationalism, and the random effects these may have on policies and confidence, along with the possibility of another Persian Gulf crisis affecting oil prices, and you can see why financial markets are skittish.

Look one way and you can see in the marketplace something between complacency and exuberance. Look the other way, and there is fear. The financial cycle is not necessarily signalling the end of the expansion this week, or at any time specifically, but it is conveying a “fragile: handle with care” warning. There are plenty of catalysts to set off a retrenchment cycle in the long march of financial and real estate assets as a share of GDP, that dates back to the mid-1990s.

All too soon, we will have to make big decisions about how to mitigate the consequences of recession. And from a position in which conventional monetary policy tools and even quantitative easing offer precious little hope of redress.