Is U.S. Recession Imminent?

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Summary

The US is presently seated in the fourth-longest economic expansion in its history, roughly 30 months from what would match the longest on record.

Asset valuations remain lofty, but are partly supported by a secular compression in long-run interest rates.

The debt-to-GDP ratio in the US continues to widen - unsustainable in the long run, but impossible to ascertain a "tipping point".

To fall into recession by 2019, it's likely that a shock will need to manifest in a well-tentacled sector that exploits the high degree of non-financial corporate debt.

The US is currently in the fourth-longest expansion on record, behind only the 10-year expansion from March 1991 to February 2001, nine-year expansion from March 1961 to November 1969, and eight-year expansion from December 1982 to December 1990.

(Source: US Bureau of Economic Analysis; modeled by fred.stlouisfed.org)

The current recovery is approximately 7-1/2 years old. While this may be interpreted as a sign that this cycle may be getting long in the tooth, the present longevity of an economic cycle has little relevance with respect to the odds of a downturn. Growth has averaged just 2.11% annualized since the recovery officially started in mid-2009, whereas many recoveries, as illustrated above, have sharper growth peaks toward the beginning of the cycle, or at least average 3.5-4.0% annual real growth by recouping lost jobs and other economic inputs that were previously lost.

Despite the disappointing growth figures, there is no reliable indication that inflation will pick up to the point of effectively overheating the economy. It may be reasonable to expect that some type of adverse shock will likely need to materialize for the US to slip back into recession within the next couple years.

Asset prices remain elevated and recently all four of the major US stock indices (SPY, DIA, QQQ, IWM) recently made new all-time highs. The long-run downtrend in the effective federal funds rate (shown in the diagram below) is bullish for stocks even if the lower economic growth translates into lower earnings growth.

(Source: Board of Governors of the Federal Reserve System (US); modeled by fred.stlouisfed.org)

With stocks and bonds valued as a series of cash flows discounted back to the present, compressed discount rates (partially a function of overnight rates set by the Federal Reserve) allow for the same amount of earnings to trade at higher earnings multiples.

So, while asset prices may remain elevated relative to historical norms at a price-to-earnings ratio of 24-25x versus 14-16x as a long-term median or average, it is at least partially reconcilable to the fact that interest rates effectively remain in emergency mode throughout the developed world (i.e., negative in real terms).

Naturally, some of the uptick in asset valuations has come via central bank actions. Savers have been significantly disadvantaged due to poor return offerings, as a consequence of ultra-low rates, designed to stimulate lending demand and buoy up modest growth levels. Buying into high-quality bonds is a poor risk-reward proposition stemming from quantitative easing programs bidding up the prices of Treasury bonds (due to Fed purchases), which forces investors over the risk curve in order to generate even modest returns. Namely, today's valuations are some combination of the usual fundamentally-driven estimated guesses of future performance and the flow of capital from yield-challenged asset classes to riskier assets.

There is evidence that much of the downshift in real interest rates is secular in nature. Aging demographics throughout the developed world point to the general idea that consumption per individual should be theoretically lower (older individuals consume less than younger people). As economies mature over time, quality of life improves, innovation slows, life expectancy increases, fertility rates decline, and labor force participation decreases. As a result, the capital-to-labor ratio increases, and recent quantitative and credit easing programs that have massively expanded the money supply have gone so far as to engineer a further skewing of this relationship, with the quintupling of the Fed balance sheet since the fall of Lehman Brothers in September 2008.

(Source: Board of Governors of the Federal Reserve System (US); modeled by fred.stlouisfed.org)

Therefore, in large part due to demographic factors, interest rates should follow a secular decline moving forward - albeit, in the long term, ideally somewhat elevated above their current rates for the sake of general economic balance.

The Debt-to-GDP Influence

A key measure of assessing recession risk lies in discerning where a country is regarding its comparative degree of income growth relative to its credit growth.

Without credit, economic growth is simply a function of labor force productivity; with credit, economic participants can exceed the rate of productivity growth by borrowing. Nonetheless, at some point, this borrowed money must be paid back (with interest), which causes complications if and when an endogenous or exogenous shock hits the economy, leading to downturns. The cyclical pattern observed in economic systems is hence fundamentally caused by the uptake and pay-down of this debt.

A country cannot grow its debt faster than its aggregate economic growth over the long run. Yet, the US has had its non-financial corporate leverage outstrip the rate of its real GDP growth since Q3 2006.

(Source: US Bureau of Economic Analysis; modeled by fred.stlouisfed.org)

While non-financial corporate debt has risen rapidly relative to real GDP, it is nonetheless more affordable at the current rates available in the market. Even so, lofty asset valuations and higher amounts of non-financial corporate debt can augment an economy's susceptibility to internal or external shocks, such as a tightening of the money supply or a sector-specific blowup that rapidly eliminates vast quantities of wealth or has macro-related ripple effects.

A Shift from Monetary Policy to Fiscal Policy?

Lowering corporate tax rates to ensure greater global business competitiveness, rolling back excessively constrictive regulations, repatriating overseas cash, and modernizing the country's infrastructure are all sound plans to boost economic growth. On the other hand, keeping tabs on the budget deficit and avoiding a continued buildup of the national debt are essential items to avoid straining the financial health of the country.

The Fed's policy response to the financial crisis was so aggressive that a real de-leveraging never had any true possibility of transpiring. The Fed's (and by extension, other central banks) current monetary experiment may be technically smoothing growth, but comes at the cost of having pulled a massive amount of growth forward from the future through the enticement of cheap credit to incentivize immediate consumption.

Reform at the government level to shift the focus from the bold financial engineering characterizing today's monetary policy to the more organic focus of fiscal policy is a step in the right direction. But the simultaneous expansion of cheap credit, falling operating cash flow, and heavy investment of said debt into share buybacks rather than organic growth measures (e.g., capital expenditures) points to a substantial degree of unproductive economic behavior.

The first two circled areas below indicate net debt-to-operating cash flow ratios just prior to the previous two recessions, with the third roughly indicating where we were when the Financial Times produced this graph earlier in the year. The two metrics, based on incentivizes largely introduced from central bank policies, are also trending in opposite directions:

(Source: Financial Times)

Recap

Though the notion that we are in one of the largest economic expansions in US history is true, it does not provide critical insight into how much longer the current cycle can run. While we have seen an expansion as long as 10 years, which can act as a general barometer of what may be considered normal, we have, on the contrary, never once experienced such a radically dovish monetary policy experiment in the Fed's history. Such expansionary policies can extend business cycles beyond whatever historical precedent we might be inclined to rely on.

Moreover, despite stretched asset valuations, the current ultra-low rate environment can realistically support prices beyond their historical averages through the effect on lowering company's cost of capital.

On the other hand, an over-reliance on aggressive monetary policies and the capital misallocations they can create leave some degree of concern. Credit has expanded at a rate faster than real GDP each quarter for 10 consecutive years and much of this debt has been pushed into financial engineering measures, such as mergers, acquisitions, and share buybacks, rather than organic growth measures, such as optimal levels of investment into physical and human capital.

Nevertheless, given there are few signs of any economic overheating, a recession within the next couple years would likely be a consequence of some shock that exploits the high degree of leverage currently observed in the non-financial corporate sector.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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