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Doomsday Preppers: The Most Likely Paths to the Next Recession

2019년5월13일 - 3 분 읽기

It’s hard to see a recession happening this year … but careful investors should always keep an ear cocked to the whispers of the disparate doomsayers.

If the secret to happiness is exceeding expectations, then there are few better paths to contentment than awaiting disaster. Even after the recent trade escalation, we’re sticking to our constructive view of the global economy this year, but it’s probably good practice to look at the darker alternatives like folks who think the world is on the verge of total calamity

To be clear, it’s hard to see a recession happening this year given the combination of strong U.S. consumption, Chinese recovery and accommodative central banks. But careful investors should always keep an ear cocked to the whispers of all the disparate doomsdayers. Like Chicken Little, they’re probably wrong. But they only need to be right once. 

So let’s run through some potential scenarios for the next global recession.

1. Too much U.S. household leverage?
With the scars of 2008 still visible, it’s hard not to imagine that the most likely source of the next unraveling will be an over-optimistic, over-stretched American consumer. And yet there’s little sign of stress in household debt numbers. There may be worrying trends in automobile and student debt, but these are hardly the stuff that will trigger a recession on their own.      

TOTAL U.S. HOUSEHOLD DEBT

Source: Factset. As of December 31, 2018

U.S. HOUSEHOLD DEBT GROWTH BY CATEGORY

Source: Factset. As of December 31, 2018

2. Too much U.S. corporate debt?
The numbers for U.S. corporations are more disconcerting, but it’s important to pinpoint the real problems. In fact, the highest debt levels in the S&P 500 are in real estate and utilities sectors, which typically generate plenty of cash to meet any obligations. Smaller firms are beginning to show signs of potential stress, but again the averages probably hide a wide dispersion. If rates trend too high, there will surely be isolated losses. To be a systemic issue, there would have to be a scenario in which a few defaults would trigger a lot of defaults across the Russell 2000, and that stretches the imagination right now.

S&P 500 MEDIAN NET DEBT TO EBITDA

Source: Deutsche Bank, Bloomberg. As of May 3, 2019

RUSSELL 2000 NET DEBT & EBITDA

Source: Deutsche Bank, Bloomberg. As of May 3, 2019

3. Too much U.S. government leverage?
There was a time when the U.S. government deficit and debt level triggered a rigorous debate over what is affordable, what is sustainable and how we could foist such burdens on future generations.  Clearly, borrowing in the world’s reserve currency carries enormous advantages, but most important is the widely-held assumption that the U.S. generally grows faster than other parts of the world. As long as the business model remains sound, there’s no reason to believe that debts are not sustainable. These assumptions could change slowly if politicians continue to cut taxes and increase spending. They could change quickly if rates spike and drive up the servicing costs, but for now the dynamics look stable.

GOVERNMENT DEBT SERVICE TO GDP​​​​​​​

Source: Factset, Haver. As of December 31, 2018​​​​​​​

GROSS GOVERNMENT DEBT TO GDP​​​​​​​

Source: Factset, Haver. As of December 31, 2018​​​​​​​

4. Too much European debt?
If you run out of things to worry about in America, there’s always Europe.  For demographic reasons, Europe will never grow as fast as the U.S. Robust social safety nets keep taxes higher and companies less nimble.  But what really worries most people are the public debts that mostly rocketed with bank bailouts during the European financial crisis. Italy’s government debts get most of the headlines, at 130% of GDP, but even the new populist government’s budget has a surplus before interest payments. And most of the bonds are held by Italians who are more than happy to roll them over and enjoy the higher yield. But that points to another vulnerability: European debts are held less and less by non-residents, which means governments are increasingly dependent on their own banks.  And vice versa. We’re not there yet, but these were the main ingredients of the crisis that nearly scuppered the European project just a few years ago.

DEBT SECURITIES HELD BY NON RESIDENTS​​​​​​​

Source: Bloomberg, Haver. As of December 31, 2018​​​​​​​

BANK ASSETS AS A % OF GDP​​​​​​​

Source: Bloomberg, Haver. As of December 31, 2018​​​​​​​

5. Too much Chinese financial leverage?
There are plenty of reasons to worry about China, but near the top of the list are its policy complexity, its patchy transparency and its mounting debt.  While Emerging Market debts have been broadly under control, Chinese debts have been rising steadily. The bulk of these are to the state-owned companies the government must support to maintain jobs and growth. There’s little risk that this will come cascading down as long as policymakers hold all the strings they need to manage the process. More concerning is the growth of Chinese ‘wealth management products’ which could be vulnerable, although authorities have made progress reigning in non-bank lending last year. For now, a closed capital account means that Chinese financial risks should mostly stay in China. Still the worrywarts will keep an eye on debt service costs, which are volatile and rising.   

TOTAL CHINESE DEBT BY SECTOR​​​​​​​
Source: IIF, Bloomberg, Haver. As of April 30, 2019​​​​​​​

CHINA DEBT AND DEBT SERVICING COSTS

​​​​​​​Source: IIF, Bloomberg, Haver. As of April 30, 2019​​​​​​​

If the next recession is sharp and unexpected, of course, it will not stem from any of these sources. It will come out of nowhere.  It will be a collapsing hedge fund that no one ever heard of. It will be an evaporation of liquidity somewhere in the system that triggers a broad rush to safety. It will be a cyber virus that no one knows how to stop. 

These are risks that are almost impossible to plan on and can keep you from taking any reasonable risks at all. So best not to count on doomsday, but to invest thoughtfully and keep an ear to the ground for the most reasonable things that could go wrong.

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