Pricing a US Recession Won’t Make it Real
One of the main drivers of global markets at the moment is the exact status of the economic cycle in the United States, and on a related note, what the Federal Reserve’s next moves are likely to be. One question we are being asked more and more often by investors is whether we think a recession is coming in the US, and if so, when?
While it is fair to say the probability of a recession in the future has recently increased given that the data has deteriorated, there are two questions that are more important to us. Firstly, are we seeing a marked slowdown? And secondly, what are the consequences of a marked slowdown for default rates?
In seeking to answer the first question, it is important to remember that recessions are an ex-post event (the technical definition being two consecutive quarters of negative quarter-on-quarter growth) so we only know about them with a lag of several months. Ex-ante, however, if there is a marked slowdown then market prices will most likely discount a recession at some point. There is an additional premium required to buy assets in the midst of a noticeable slowdown as no one knows how far it will go. Therefore ex-post it can look like prices overshot. For a good example of this we need only look back to early 2016, where we witnessed a marked slowdown in the US, but no recession. Price action in certain parts of the market was quite severe, the energy sector being the most obvious example. Turning back to the present, if we look at growth projections for the US today, we can see there is a marked slowdown forecast – from GDP growth of just under 3% in 2018, down to the mid-to-low 2% area in 2019, and then to anywhere between the mid-to-high 1% area and 2% in 2020. This is significant.
So on to question number two: what can we expect to happen to default rates as a result of this projected deceleration? The answer depends on a number of factors, but we believe a recession would have a bigger impact on default rates in the US than in Europe and the UK. One of the reasons for this is that corporate leverage in the US has increased steadily after falling as a result of the crisis in 2008/9. In fact, US corporate debt as a percentage of GDP is back at the highs of 2008/9. In addition, the surge in corporate debt over the past seven years has been characterized by “large increases in risky forms of debt extended to firms with poorer credit profiles, or that already had elevated levels of debt,” according to the Fed’s latest Financial Stability Report.
It isn’t all bad news, though. The banking sector is in good shape and so is the US consumer. Unemployment is low, financial conditions remain reasonable and household debt has steadily declined since 2009. Even in the corporate space we have strong interest coverage trends as a consequence of years of low rates. The increase in corporate leverage is a consequence of the benign growth environment the US has been experiencing for some years now. This makes debt funded M&A, capex plans and equity buybacks an attractive proposition for shareholders. By contrast, in Europe growth has been subdued so the incentive for companies to carry out this type of transaction has been much lower. Leverage and credit quality have therefore not changed dramatically, which is reflected in a ratings upgrades vs. downgrades ratio that has generally speaking been better in Europe than in the US since Europe’s sovereign crisis. In fact, Germany narrowly escaped a recession in the second half of last year and default rates haven’t really moved from very low levels.
In conclusion, we do not think the US will experience a deep recession. Technically there might not even be a recession, which is not to say that markets won’t price one in. But there are enough indicators out there that point to the economy actually being in the later stages of the cycle (we’ve discussed a couple of them here but another obvious one would be the shape of the yield curve). Risk-reward for spread products is less attractive in this environment, which is why we remain overall cautious when it comes to credit risk and credit spread duration. This not only applies to US credit but credit markets in general, given the importance of the US economy and credit markets globally.