In this article, we are going to take a look at some good reasons why we should expect another economic recession and why it is a written story.
This happened over and over again in the past and since those mechanisms are intrinsic in how our economic system works, you should definitely expect to see that again.
Without further ado, let’s start by looking at one of the most important sources of growth and also instability in the system.
Debt cycles are a fundamental component of how capitalism works.
Debt dynamics inevitably create debt cycles. Basically, the assumption of debt makes it possible to expand economic growth above the productivity level and by decreasing the cost of borrowing currency. Lower interest rates coupled with optimism toward the future from consumer and enterprises, determines an increase in consumption and investments. In this case the mechanism works as a self-reinforcing upward cycle.
The problem with debt is that a higher consumption today equals a subtraction of purchasing power tomorrow, when debt has to paid back. Furthermore, often times payments are correlated with the level of interest rates.
After the dotcom bubble, the accommodative monetary policy helped to create the housing market bubble where everyone, from individuals to financial institutions, was highly leveraged.
One useful observation that should be made in order to understand the current situation is that right now the level of debt is far larger than 2008.
If you look at the mortgage debt probably you won’t get an idea of the whole leverage that there is in the economy, it is just as the level of 2008.
So what about the higher level of debt? Where is all that debt?
As Mark Twain said:
“History doesn’t repeat itself but it often rhymes”.
There is a strong parallel with 2008, what has changed this time is the allocation of debt.
While the housing debt is relatively the same, government debt, business debt and consumer debt all have exploded.
As you can see from the chart below, the total amount of federal debt has started to increase significantly from 2000s and after the 2008 crisis it skyrocketed.
From the first half of 2008 (at this time it was around 10 trillion) the 2018 level of public debt doubled, with an increment 107%.
There has been a general tendency to get as much debt as possible and government debt is not alone. Indeed, when you look at how businesses are positioned, here’s what you find:
Private companies took advantage of low interest rates to get more leverage and the trend is very similar to public debt. In 10 years, we find that debt level has increased 76%, from 3.5 to 6.2 trillions of dollars.
As for consumers, the situation in even worse. This is debt that was used to purchase stuff at credit, it is not something that went into productive goods.
Consumers used more and more debt to finance their consumption and this trend seems to increase without any other direction, right now is 48% than the level in 2008 before the crash, when the economy was still doing very good.
Do those indicators sound like warning signs? This time instead of housing, debt went to government, companies and consumers.
Government had to face the recession, implement social policies and generate fiscal stimulus.
Meanwhile, corporations took advantage of low interest rates to leverage themselves while consumers spent more and more thanks to easy and cheaper loans.
Those data are referred to US but we saw similar situations in Europe, China, Japan and other developed countries.
Corporations, governments and consumers are all leveraged, those things are likely to end up bad.
The takeaway from those charts is that everything that is going on here in the economy is financed mostly by debt.
When this trend reverses it becomes a self-reinforcing downturn.
Why should it reverse? There is a limit to how much debt economic operators can take, sooner or later, after the levels of income and spending surpass the productivity growth of the economy, they will fall since debt has to be paid back and the level of income available for consumption will be less.
Less spending and less consumption mean less economic activity, that is less investments and less jobs. This causes less lending and the downward cycle reinforces.
Debt and interest rates are strictly correlated. One key point is that right now interest rates are still low. As interest rates gets higher, two effects occur:
- Interest payments become more expensive, putting a burden on those who are highly leveraged, that is everyone in the economy as we just saw from the charts above.
- Bond prices decrease. The sensitivity of bonds to short term rates is another factor that requires attention. This affects portfolios as well as returns that must be offered to the market. Furthermore, during an economic downturn, and certainly in a recession, mass downgrades of debt occur. If the rating goes below certain levels, many investment funds simply have to sell them because they became junk.
- The debt burden is certainly one of the most preoccupying thing. As rates increase, the debt burden will become huge and will lead to an inevitable collapse.
Take for example the current US government expenditures for interest payments.
Right now is more than $ 500 billions at the current level of interest rates.
- Right now a significant portion of the budget is used to pay the interests on the debt from the past. If the government continues to issue more debt to cover interest payments, at some point in time those payments that are growing and growing will become a larger and larger burden. Just like a Ponzi scheme, it has to collapse at some point, and when it happens there is a debt crisis.
- Those levels of expense for interest payments is happening right now, in current economic good times during the second longest economic expansion in recent history coupled with lower interest rates. Guess what happens as the FED progressively rises interest rates or, even worst scenario, in the case of a recession.
Debt is good for capitalism to work, but high levels of debt creates and element of fragility in the system.
How do you pay debt?
- Through productive investment that increase productivity and generate more income than interest expenses
- Through inflation, by debasing your currency. But it causes inflation and it is something that is difficult to control. Monetary policy can’t change our behaviours, if we know that there will be inflation we will move consequently causing hyperinflation. It erases the debt but causes a lot of other problems.
- The third option is default or restructuring (that often times assumes the form of a lighter and partial version of a default)
By expanding debt we are pulling tomorrow’s prosperity into today, but as 2008 showed when debts stops growing the whole system stops. Our current monetary system is either expanding or threatening to collapse.
This is a real big problem that puts the FED in a difficult position: avoid generating inflation through currency debasement (that is exactly what happened with QE) or stimulating the economy.
Right now we are talking about tapering but given the hard political acceptability of the decision, it is likely that the FED will chose to be even more expansive and go for monetary stimulus.
One could arguably say that monetary policy is the ruler of the economy. Everyone pays a lot of attention to the decisions made by central banks because they are fundamental in determining economy direction.
After the financial crisis of 2008 we saw dramatic measures aimed to stimulate growth. Interest rates were brought down to zero and after a short time they proceeded with the Quantitative Easing (QE).
The QE is basically a monetary stimulus to the economy that boosts growth through the creation of a larger amount of currency.
Right now interest rates are still accommodative, but central banks (not only the FED) are talking about tapering, that is to progressively reverse the monetary creation generated with the QE.
The main problem is that this operation by the central bank causes interest rates to increase and this could be really bad for the whole economy and could potentially trigger a new recession.
The reason why this matters is the astonishing level of debt that there is out there. Individuals are in debt more than they were back 2008 (with more credit card debt, student loans, car loans… many people live paycheck to paycheck), government debt has exploded and companies are highly leveraged.
This causes problem about:
- Public debt service and refinancing
- More expensive loans → less consumption
- More expensive loans → less investments
- Problems with refinancing of debt
- Mortgages becomes more expensive → less home sales, problems with existing mortgages, defaults
As Ray Dalio pointed out in recent interviews, we are in the late part of the cycle where QE has used most of its power.
Asset prices are up, interest rates are low and we are beginning a tightening on monetary policy, similar to the one in 1937.
We are in the part of the cycle where monetary policy is tightening and the economy starts to slow down, if interest rates rise faster than it is discounted, it can hurt asset prices (that are fairly fully priced at these levels of interest rates, they can only go down).
One important observation about public debt is that it usually correlates with GDP growth (at least it should do so), but if you check it out you notice that it is growing much more, it is diverging.
Right now, while “the economy is doing great”, the budget is already stimulative: if there is a recession it has to increase and that can be a problem because of interest rates the cost of financing that debt increases.
Interest rates could move up very quickly and by a large amount, and because there is so much debt that means enormous amounts of money.
It is a self reinforcing spiral. Think what it does to the federal budget alone: if interest rates moves up the deficit skyrockets, the US have to sell more bonds to finance it.
That would put more downward pressure on bond prices and more upward pressure on interest rates, that sums up with the monetary policy interest rate hike.
As rising interest create bigger deficits, those bigger deficits creates rising interest.
The fact now is that US can’t withstand a rise in interest rates. That puts the FED in a very difficult position. Monetary policy should regulate the economy, slowing down the economy when it is going too fast and helping when it is too slow. It should avoid the creation of bubbles by rising interest rates before it is too late. One of the main problems of rising interest rates is that, given the amount of debt, it may trigger a recession, and no central bank wants to have the responsibility of a recession.
After the crisis, large amounts of currency were created and put into circulation, this stimulated the economy but helped to create a bubble that is even bigger.
As interest rates go up, the dollar strengthens, this has a negative effect on exports (not a good news for the US) while causing problems to emerging countries with dollar denominated debt (not a good news for the world economy).
Do you really think that there will be any tapering when interest rates rise, when public debt increases, when the economy will significantly slow down and when the dollar will become stronger?
If the dollar becomes too strong, the tightening needs to slow down. The more bonds the treasury has to sell to finance debt, the more dollars the FED will have to create if it wants to buy them to prevent the rates to increase. That is the opposite of a tight.
In case of recession, it is very likely that we will see another monetary expansion, this time even bigger.
Considering what was done in the past, the current level of interest (that is already very low) and the breadth of central banks balance sheets, one of the things that we can reasonably think is that
During the next downturn, monetary policy won’t be able to be as effective as the last time.
Right now the FED, as well as other central banks, is talking about tightening, in the near future we may see a reverse in their policy.
Market Valuations and Growth
When it comes to investing, you certainly care about your expectations about future movements of the market. How you formulate your expectations is another story, but you might want to consider what the market has already done and where it is potentially headed.
Right now, indexes are at record highs and everybody is convinced they have no place to go but up. Investors have been very optimistic, far more than back at the top of dotcom bubble.
The enthusiasms about tax cuts, about how great everything is, about this booming economy that we have… are really dangerous.
Everybody likes when markets go up, but if you care about your investments you should consider:
- Why their prices are increasing?
- Is it sound growth?
- How much can they further increase?
To put things in perspectives, here are some charts that can help you to get an idea of America’s markets. Given the breadth and the worldwide importance of those markets it is worth to take a look.
The index shows a nice +322% from the bottom during the crisis to its top in this years and +105% from the top in 2008.
If we consider the correction during the last few months we are around +311% from 2009 bottom.
In order to frame the last ten years in the big picture, here is the long-term chart starting from 1990 (+729%).
As you can see the “irrational exuberance” that preceded the 2008 crash is really nothing compared to where we are today.
Also the Dow Jones shows a significant growth of 304% from the bottom of 2009 and +105% from the top in 2008. Recent corrections brought those value at 292%.
Again, to put things in perspective, here is the long-term chart starting from 1990. The performance of the index in 2018 is +864%.
The Nasdaq performed even better, recording a +527% from the bottom in 2009 to the top in 2018 (+221% from the top in 2008) and taking into account the recent corrections the performance is around 470%.
From 1990 until today the index recorded 1670% in its value, not bad.
Now, what all those charts mean?
Surely the economy has grown over the years, progresses and new inventions were made, the competitive scenario changed dramatically and new dynamics formed.
While I am enthusiast of technological change and economy evolution, I am little bit more sceptic about the new dynamics.
Why are the markets doing so well?
I think that those charts are quite scary for the following reasons.
- When talking about the new market dynamics, what about the driver called monetary policy? The Quantitative Easing is like drug for markets, I am sure that you remember that last time that there was easy money we had a big housing bubble. This time the effects of QE showed up in financial markets (and also resulted into more and more debt, that skyrocketed both for government, companies and households, which financed spending), this clearly means that prices don’t reflect value and that sooner or later there has to be a major correction.
- The value of a company should reflect its earnings and its growth potential. When you look at the earning you notice that most of the companies who are doing well are just slightly above the levels of 2008, certainly there wasn’t a three-fold increase in their earnings as there has been a three-fold increase or more in the market. Furthermore, what creates real and solid growth in the economy over the course of years is productivity, and that really didn’t increase that much.
- Those trends are definitely not sustainable, not even in the short term. We have already been in economic expansion for years. Do you seriously expect to see other 5 or 10 years of this growth? How long do you expect this to continue?
From 2009 we have been seeing nothing but growth at rates that are impressing, it is reasonable that now we are approaching the end of the cycle.
Just by watching the charts look at how much and how fast market valuations went up, history clearly showed that those things end up bad.
As for growth, we are in the second longest economic expansion in history, how long will it last? You may want to consider this fact while making the evaluations for your investment decisions.
Record high stock prices create a positive sentiment that they will be maintained during the foreseeable future. The predominant sentiment seems to be that current valuations will stay forever.
Market indexes went up by roughly 300% since 2009 but the GDP, as you can see from the chart below, grew only 42% over the same time period.
From a fundamental perspective, it clearly seems that the market is exuberant.
Furthermore, how much of the GDP growth if purely financed by debt?
History speaks clearly, in 1929, 1987, 2001 and 2008, every time that investors believed in endless growth in order to justify current asset prices, a painful correction came to remember what was the reality.
Along with the markets, households wealth is experiencing an unsustainable bubble.
Those value of net worth are just on paper, as the market changes net worth changes too, this is very similar to the housing bubble of the years 2000s.
When people start to feel that their wealth is going away, fear comes into play and their behaviour certainly shift.
So, what should you expect for the coming years?
I’d really like to know that in the comments.
What I don’t expect is another 5-year period of economic expansion at the same pace we have been seeing recently.
Is the financial system in the process of breaking down, as it did in 2008? Not yet, but you may want to take into account a similar scenario for the future.
Why we had a financial crisis last time?
Because we had too much debt.
Guess what? Now we have much more!
allows to boost economic activity. Low interest rates along with
optimism toward the future push consumers, enterprises and government to
spend more than they have.
This time this mechanism was amplified thanks to ultra-expansive monetary policy.
The point is that more spending today is equal to less spending tomorrow: after the economy expanded, when interest rates start to rise and debt has to be paid back or refinanced, it puts a huge burden on the whole economy.
Also, market valuations are pumped-up prices made possible low interests and lower taxes. It is just paper value, not real value. The dividends that you get and growth perspectives are value. That’s not sustainable in the mid-long term.
We are already seeing some early warnings today, you don’t need to wait it to happen in order to decide to be prepared.
Throughout 2018 we already saw a significant decline in emerging markets and a slight decline in US stocks, while there was not a sudden reaction by markets because prices declined over 3–5 month period.
recap: government debt skyrocketed, consumers bought on credit and
companies are more leveraged than ever before. The real estate market is
highly correlated with mortgage rates (and most people expect that
mortgage rates will remain at this level forever).
Market valuations are at all time high and the sentiment is that they are going to stay.
Be careful and remember that as interest rates rise this becomes unsustainable.
Interest rates are already increasing and there is a program for a series of hikes in the next 18 months.
Remember that interest rates act like gravity on the economy and that we are in a situation in which central banks ultimately decide on the faith of the entire economy.
As an investor, you should consider to limit your downsides because if this “everything bubble” pops, things are going to be much worse than 2008.
Finally, I’d like to remember you that at the same time, the next global recession will be a great opportunity for a lot of smart investors out there who positioned themselves to take advantage of it.
This article is for informational purposes only, it should not be considered financial advice.
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