Recession Risk Looms

The global economy entered a period of high inflation in the second half of 2021, after a prolonged decade-plus regime of low inflation. Globally, central banks started to hike rates in March 2022, with the Federal Reserve increasing their policy rates at the fastest pace in the past 40 years to 5.5%.

The US economy has remained unexpectedly resilient since the first rate hike; growth has been supported by the excess savings from fiscal stimulus programmes and an easing of global supply chain pressures. Inflation has significantly declined since the 2022 CPI peak of 9.0%, but the current level of 3.0% is above the Fed’s 2.0% inflation target. The risk is that additional disinflation may occur by year-end and into 2025 and, therefore, monetary policy will be too tight as real rates rise.

We believe that the likelihood of a recession, stemming from the rapid rate hikes, has been delayed but not derailed, as monetary policy works with a lag. The US economy is showing growing signs of deceleration, weakness and disinflation, and market expectations are that the Fed will cut rates by 0.25% in September which leaves them well behind the curve. We expect that the Fed will not shift to a full-blown preemptive easing policy framework as their data dependent framework (i.e., backward-looking framework that focuses on lagging indicators) needs to see much weaker data to ease aggressively; an aggressive Fed policy response will likely occur only after a recession hits.

It is difficult to predict the precise timing of when a recession will occur. If we use history as a guide, a recession could emerge in the near term: Per Jim Reid at Deutsche Bank, the average time to a recession after the first rate hike is between thirty-seven and forty-two months, which would put the start of the recession in 2025.

We believe that leading tech-enabled lending strategies, like Fasanara’s, should prioritise the use of credit enhancements to mitigate the elevated risk of a recession to embed downside credit risk protection in the portfolio to generate more stable, persistent returns. These credit enhancements (first-loss policies, credit insurance, corporate/government guarantees and others) will add much needed protection and reduce the risk of default and delinquency. Given the heightened recession risk, we believe that a favourable tradeoff exists between the modest cost of these credit enhancement tools and the amount of risk reduction and return enhancement that they provide.

Why Inflation Spiked in 2021

The current inflation spike was not the typical wage-driven cost spiral inflation, but was driven by COVID-related supply shocks and massive fiscal and monetary policy stimulus (trillion dollar infrastructure bills and COVID stimulus packages). The 2021 inflation spike was global in nature: even Japan experienced a rise in inflation after being mired in a 30-year period of zero inflation despite extraordinary fiscal and monetary stimulus.

Source: Cicadian-rhythms, JPMorgan, Eye On The Market

We believe that the current bout of global inflation is unique and stems from the history-making governmental responses to the 2020 pandemic. The drivers of the current inflation shock were both a negative supply shock coupled with excess demand:

1. Unprecedented world-wide negative supply shock caused by global government mandated lockdown policies. The negative supply shock was driven by the shutdown of SMEs, with companies positioning for lower expected demand and a breakdown in global supply chains. In the US, this negative supply shock was partially offset by a positive supply shock related to the surge in illegal immigration during this time period.
2. Excess demand was created by the extraordinary monetary and fiscal stimulus (helicopter drops) designed to keep the global economy afloat the during the pandemic era lockdowns, which resulted in significant excess savings by US consumers, as they had a limited ability to spend. The enormous amount of emergency fiscal stimulus overrode the normal business cycle and led to fiscal dominance (fiscal policy overrode inflation-targeting monetary policy).

Source: Cumulative Pandemic-era Excess Savings, Federal Reserve Bank of San Francisco

Monetary Policy Response

Global central banks responded slowly to the 2021 inflation spike, calling it transitory in nature, as it appeared to stem from the global breakdown in supply chains. However, starting in March 2022, the Federal Reserve hiked their policy rates at the fastest pace in the past 40 years from 0% to 5.5%, with the stated goal of tightening financial conditions to bring inflation down. Inflation has significantly declined since the 2022 CPI peak, but is still above the Fed’s 2% inflation target driven by sticky non-discretionary services.

Source: Bloomberg, accessed on 28/2/2023

Why No Recession Yet?

In 2022, it was widely anticipated that the sharp rise in interest rates, which were designed to tighten financial conditions, would cause a recession in 2023 or 2024. Rising interest rates typically cause a recession through discouraging new investment. Higher rates have a lagged impact on consumers and corporations given the fixed rate maturity profile of a high percentage of US consumer and corporate debt. In fact, the economy has been supported by many positive developments as outlined in the table below. It is interesting to note that financial conditions have loosened since the rate hikes started with an increase in household leverage, which has been supported by fiscal stimulus and rising labour force participation.

Financial Conditions Have Loosened

Source: Chicago Fed National Financial Conditions Index, Federal Reserve Bank of Chicago

The US economy has become extremely bifurcated post the pandemic. There are a minority of wealthy households who are not impacted by higher interest rates as their consumer spending has been supported by the record increases in household wealth as housing prices and equity markets have exploded higher. The majority of US consumers are impacted by higher interest rates and inflation as they do not benefit from the wealth effect; they are faced with higher rents, house prices and mortgage rates, stagnating real wages and now a growing need to access (high interest) debt to finance their spending.

Recession Risk Signals

We believe that there is an elevated risk for a near-term recession. The factors in the table below outline some of the key risks that we are monitoring.

a) Inverted Yield Curve The US yield curve has been deeply inverted for an extended time period since 2022. This has historically caused a recession one to two years post the initial rate hike.

Source: 10-Year Treasury Minus 2-Year Treasury, Federal Reserve Bank of St. Louis

b) Rising Deflation Probability Per the St. Louis Fed, there is an increase in the probability of deflation over the next year. The deflation probability has increased to levels last seen almost ten years ago (excluding the COVID time period). The risk is that inflation may drop below the Fed’s 2% target by the end of 2024 and the Fed will be significantly behind the curve by keeping rates too tight, thereby causing a recession.

Source: https://www.rosenbergresearch.com/

c) Slowdown in Consumer Spending & Rise in Delinquencies US consumers were well supported during the pandemic as year-over-year real disposable income growth was robust and excess savings skyrocketed to $2.1 trillion in August 2021 as the economy came to a hard stop given the business closures and lockdowns. These favourable tailwinds have now reversed. Real disposable income growth has declined and the excess savings have now been fully utilised. The majority of US consumers are now reliant on debt to fund consumer spending and there are growing signs of a slowdown in this regard. The risk is that as consumers run out of savings, there will be a sharper decline in discretionary spending. Consumers will need to borrow at unsustainable levels to finance their spending which may result in a large increase in delinquencies and defaults, as economic growth declines and unemployment rises. We are beginning to see evidence of this beginning to occur as credit card and auto delinquencies have started to increase. The US consumer is under stress as can be seen from the decline in the savings rate which has been offset by the dramatic rise in outstanding credit card debt.

Increase in Credit Card & Auto Loan Delinquencies

Decline in Personal Savings Rate & Increase in Credit Card Debt

Source: Oxford Economics/Haver Analytics

Anticipated Recession Policy Response

The policy response to the recession will probably be the usual mix of steep rate cuts, quantitative easing and fiscal stimulus. This will likely lead to a ‘catch-22’ scenario of the policy response leading to higher inflation and causing a need to re-tighten policy to move back to the 2% target. The Fed has cut rates by 500 bps on average during recessions, this would move rates back to the zero bound.

Source: https://www.rosenbergresearch.com/

Of note, several central banks have started to ease their policy rates in 2024 with Canada and the European Central Bank (ECB) cutting their policy rates by 25 basis points as inflation has moved closer to their inflation targets. Markets are forecasting two rate cuts in the US and the UK later in 2024 as the disinflation trend continues globally.

The Fed also faces a major policy constraint given the extreme US budget deficit relative to GDP. Any rise in interest rates causes interest expense to soar and crowds out other budget spending. At current interest rates, interest expense will become the largest budget item for the US government and will need to be financed with even more debt.

Conclusion

The Fed tightened monetary policy beginning in 2022 to try to bring the almost double-digit rate of inflation back to the Fed’s 2% target. Tight monetary policy works to discourage new investment and dampen financial conditions. Monetary policy changes always work their way through the economy with a lag; the extraordinary governmental response to the pandemic has caused unique short-term dislocations that have taken time to fully work their way through the economy.

We believe the risk of a recession is elevated and that a recession will likely occur over the near-term as the disinflation trend continues and the Fed takes too long to remove its monetary policy restraint. The inverted yield curve will lead the way in causing the recession, along with the continued slowdown in consumer spending given that the excess pandemic savings have been fully exhausted. We expect that the Fed will not shift to a full-blown preemptive easing policy framework and that an aggressive Fed policy response will only occur after a recession hits.

We believe that leading tech-enabled lending strategies, such as Fasanara’s, should use credit enhancements in the current elevated recession risk environment. These credit enhancements provide credit risk protection and help to generate more robust returns by reducing the risk of default and delinquency. The cost of these credit enhancements is modest for the amount of risk reduction and return enhancement that they provide in this elevated recession risk environment.

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