Highlights

• Slowdowns are much more likely to turn into recessions when significant economic and financial imbalances are present.
• The U.S. does not currently suffer from any of the three major imbalances that have historically heralded recessions – rapid private-sector debt growth; excessive spending in cyclical sectors such as housing, consumer durables, and business capex; or accelerating inflation.
• Imbalances are larger abroad, but not to the extent that they will trigger a global recession.
• The combination of ongoing Chinese stimulus and the lagged effect from lower bond yields will lift global growth during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind.
• Stay overweight global equities relative to government bonds over the next 12 months.
• A rebound in global growth will push down the U.S. dollar later this year, creating an opportunity to increase exposure to European and EM equities.

Feature

Global Growth At A Critical Juncture

The global economy has clearly slowed since early 2018 (Chart 1). So far, much of the weakness has been confined to the manufacturing sector. However, the service sector has softened as well (Chart 2).

Chart 1
The Global Economy Has Slowed...

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Chart 2
...Mostly Due To Another Manufacturing Downturn

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Regionally, the U.S. has held up somewhat better than most other economies. Nevertheless, the ISM manufacturing and nonmanufacturing indices have both declined, with the former now flirting with the 50 line.

All recessions begin as slowdowns but not all slowdowns end in recessions. As we discuss below, slowdowns are much more likely to morph into recessions when financial and economic imbalances are elevated. We confine our empirical analysis to the U.S., but discuss the global context later in the report.

Three Key Recessionary Imbalances

Three imbalances, in particular, have often been present at the outset of U.S. recessions (Chart 3):

Chart 3
What Makes A Slowdown Degenerate Into A Recession: Imbalances

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• Rapid private-sector debt growth: Rising debt lifts aggregate demand.¹ Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks.
• An unsustainably high level of cyclical spending: Cyclical spending includes business and residential investment, as well as spending on consumer durable goods. If spending on these categories is elevated, there is more scope for it to decline when the economy turns down.
• High and rising inflation. When inflation rises above the Fed’s comfort zone, the central bank normally needs to raise rates into restrictive territory. 

Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks.

Table 1 shows every episode since 1960 when the U.S. economy has slowed significantly. To keep things simple, we define a slowdown as a 10-point drop in the ISM manufacturing index from its recent high.

Table 1
Episodes Of Significant Economic Slowdown

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Of the 15 slowdowns that we examined, seven culminated in recessions. An average of 2.1 of the three imbalances listed above were visible prior to recessions. However, an average of only 0.9 imbalances were present when a recession failed to materialize. This supports our claim that slowdowns are more likely to turn into recessions when significant imbalances are present.

The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions.

Equities reacted very differently in the two cases. When a recession did occur following the start of a slowdown, the S&P 500 declined by an average of 3.6% over the subsequent 12 months. When the slowdown failed to turn into a recession, the S&P rose by an average of 18.3%. In the latter case, the recovery in stocks usually coincided with a swift rebound in the ISM index.

The U.S. Is Currently 0 For 3 On The Imbalance Front

The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions.

Chart 4
Reasons Not To Panic About U.S. Corporate Debt (I)

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Private-Sector Debt

While U.S. private nonfinancial debt has edged up slightly as a share of GDP since 2015, it remains well below its 2008 peak. In fact, the current business expansion is the only one in the post-war era where private-sector debt has failed to rise above its previous cycle high.

A recent Bank of England study examined 130 recessions across 26 countries. It found private debt growth matters much more for recession risk than the level of debt.²

Granted, the composition of debt also matters: While household debt in the U.S. has fallen over the past decade, corporate debt has risen. As a share of GDP, corporate debt is now at the highest level in the post-war era. That said, despite its recent ascent, the ratio of corporate debt-to-GDP is less than two percentage points higher than it was in 2008.

One drawback of comparing debt to GDP is that the former is a stock variable while the latter is a flow variable. A more sensible “apples-to-apples” approach is to look at corporate debt in relation to assets rather than GDP. If one does that, one sees that the ratio of U.S. corporate debt-to-assets is below its post-1980 average and only slightly above its post-1950 average.

The interest coverage ratio, which compares the profits that companies earn for every dollar of interest that they pay, is above its historic norm (Chart 4). Corporate sector free cash flow – the difference between profits and spending on such things as labor and capital goods – remains in surplus. Every recession during the past 50 years has begun when the free cash flow balance was in deficit (Chart 5).

In contrast to mortgages, which are generally held by leveraged institutions such as banks, most corporate debt is held by entities such as insurance companies, pension funds, mutual funds, and ETFs. Banks hold only 18% of corporate debt, down from 40% in 1980 (Chart 6). Thus, while high corporate debt levels could exacerbate the next recession, they are unlikely to engender it. 

Chart 5
Reasons Not To Panic About U.S. Corporate Debt (II)

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Chart 6
Banks Have Reduced Their Exposure To The Corporate Sector

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Cyclical Spending

Unlike a restaurant meal or a vacation, a house, office tower, factory, and automobile will usually retain some value for a while after it is purchased. If spending on cyclical items rises to a high level for an extended period time, a glut will form, requiring a period of lower production. By contrast, if spending on these items is subdued for a long time, pent-up demand will accumulate, requiring a period of higher production. 

Recessions can result from either economic overheating or financial market overheating.

As a share of GDP, cyclical spending is still far below the peaks observed during past expansions. Just as importantly, today’s low level of cyclical spending follows ten years of even lower spending. As a result, the average age of the U.S. capital stock has increased across almost all categories since 2008 (Chart 7).

Most notably, the average age of U.S. homes has risen by nearly five years since 2006, the sharpest increase since the Great Depression. Despite the rebound in residential investment from its recessionary lows, the current level of homebuilding still falls short of what is necessary to keep up with household formation. As a consequence, the vacancy rate has fallen to multi-decade lows (Chart 8).

Chart 7
The Capital Stock Is Aging

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Chart 8
There Is No Glut Of U.S. Homes

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Inflation

Recessions can result from either economic overheating or financial market overheating. Economic overheating was the dominant driver of recessions between the late 1960s to early 1980s. Rising inflation preceded the recessions of 1969-70, 1973-75, as well as the back-to-back recessions in 1980-82.

Chart 9
The 1990 Recession: A Bit Of Everything

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Overheating also contributed to the 1990 recession. After peaking in 1982, the unemployment rate fell to 5% in 1989, about one percentage below its equilibrium level at that time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989.

By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loans crisis, weakened sharply. Defense outlay continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 9).

In contrast to earlier downturns, the last two recessions were more the byproduct of financial excesses: The 2007-09 recession stemmed from the housing crash and the financial crisis it generated; the 2001 recession followed the dotcom bust, which precipitated a steep decline in capital spending.

What will the next U.S. recession look like? Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. The fact that the Fed has adopted a risk-based approach to monetary policy, which puts great weight on avoiding a deflationary outcome, only raises the likelihood that inflation will eventually move higher.

The good news is that this is unlikely to happen any time soon. While wage growth has picked up, productivity growth has risen even more. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 10).

Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating.

As we discussed in our latest Strategy Outlook, the Fed will probably not bring rates into restrictive territory until early 2022. This gives the economy plenty of breathing space.³

The Global Dimension

The discussion above has focused on the United States. To some extent, this is unavoidable. Not only is the U.S. still the world’s largest economy, but it remains at the heart of the global financial system. U.S. equities account for over half of global stock market capitalization, up from a third in the early 1990s (Chart 11). The dollar continues to be the preeminent reserve currency. As a result, U.S. financial markets drive overseas markets much more than the other way around.

Chart 10
No Imminent Threat Of A Wage-Price Inflationary Spiral

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Chart 11
The U.S. Stock Market Capitalization Is More Than Half Of Global

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Chart 12
Trade In Intermediate Goods Dominates

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This does not mean that the rest of the world is irrelevant. The global supply chain now dominates international trade. More than half of all cross-border trade is in intermediate goods (Chart 12). Irrespective of the financial and economic imbalances discussed above, a full-blown trade war would upend the global economy, sending the U.S. and the rest of the world into recession.

President Trump’s re-election prospects would plummet if U.S. unemployment rose and the stock market plunged. This is the main reason for thinking that the trade talks will ultimately produce some sort of détente. Nevertheless, a severe deterioration of trade relations remains the biggest risk to our bullish view on risk assets.

The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. Unlike in the United States, private debt has risen sharply as a share of GDP in several key economies over the past decade (Chart 13). Government debt is also a problem in countries such as Italy that do not have central banks which can function as reliable lenders of last resort.

Chart 13
Private-Sector Debt Across The World (III)

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Chart 14
Economies With Frothy Housing Markets Risk Having Deeper Downturns

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Cyclical spending is fairly elevated in a number of countries. Notably, residential investment stands at near record highs as a share of GDP in Canada, Australia, and New Zealand (Chart 14). Home prices are also quite frothy there. When the global economy falls into recession in two-to-three years, these economies will take it on the chin.

Investment Conclusions

Notwithstanding the risks noted above, we continue to maintain a bullish outlook on global equities and spread product over the next 12 months.

To paraphrase Wayne Gretzky, one should invest on the basis of where the economic data is going, not where it is.⁴ While global growth remains anemic today, the combination of Chinese stimulus and the lagged effect from lower bond yields will boost activity during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind.

Global equities are not super cheap, but they are not particularly expensive either. The MSCI All-Country World Index trades at 15.3-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 15). From an asset allocation perspective, one should favor stocks over bonds when the ERP is high.

Chart 15A
Equity Risk Premia Remain Elevated (I)

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Chart 15B
Equity Risk Premia Remain Elevated (II)

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The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13.3-times forward earnings, but it also reflects the fact that bond yields are lower overseas.

The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks.

As global growth accelerates, the dollar will start to weaken (Chart 16). EM and European equities usually outperform the global benchmark in that environment (Chart 17). We expect to upgrade stocks in these regions later this summer.

Chart 16
The Dollar Is A Countercyclical Currency

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Chart 17
EM And Euro Area Equities Outperform When Global Growth Improves

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Peter Berezin, Chief Global Strategist
Global Investment Strategy
peterb@bcaresearch.com

Footnotes

• ¹      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth.
• ²      Jonathan Bridges, Chris Jackson, and Daisy McGregor, "Down in the slumps: the role of credit in five decades of recessions," Bank Of England Staff Working Paper No. 659, (April 2017).
• ³      Please see Global Investment Strategy Strategy Outlook, "Third Quarter 2019 Strategy Outlook: The Long Hurrah," dated June 28, 2019.
• ⁴      According to Wayne Gretzky, his father, Walter, once advised him to “skate to where the puck is going, not to where it is.”

MacroQuant Model And Current Subjective Scores

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