The next US recession?

How the Federal Reserve handles the extremely low levels of unemployment will be a big test in the coming years

We are now in the eighth year of the ongoing economic expansion in the United States. This is already the third-longest expansion of the post-war era. Given how extended this cycle is, inevitably some thought must now be given to when and how this comes to an end. Business cycles have not been abolished. We will invariably at some stage have a recession, required to cleanse the system of excesses and then start the cycle once again. A recession is not a trivial matter for financial markets: Earnings will decline and equities will move into a bear market, declining by at least 20 per cent; bond market spreads will widen and corporate defaults will spike. Recessions are not kind to investors. If the US markets decline by this magnitude, it goes without saying that, all other markets globally will fall as well. Many will fall even further and faster. A US recession is therefore a big deal. When it comes, it will cause pain for all investors. Emerging Markets have historically suffered the most. Valuations are today at elevated levels across all markets. Any market reaction will be sharp and disruptive given the lack of valuation support.

Given this, is a recession imminent? Should investors start worrying and battening down the hatches?

The reality is that economic expansions do not die a natural death just from old age. There is no predetermined limit as to how long the economy can continue expanding. The economic expansion is normally brought to an end by some combination of the Federal Reserve tightening monetary policy and an unwinding of the excesses built up in the economy.

Given this framework, where are we on both these triggers?

As for the Fed raising rates and tightening policy is concerned, the process has already begun. Read the latest Federal Open Market Committee (FOMC) statement and it is quite clear that Janet Yellen is determined to continue raising rates. Given the current low level of real rates, the economy can easily handle further hikes. Another 25-50 basis points of Fed tightening should not derail the economic expansion. The risk here is the estimate of what is the real (inflation adjusted) neutral Fed funds rate — the rate at which monetary policy is neutral, neither providing stimulus nor constraining economic growth. Various academic studies indicate that this real neutral rate has collapsed over the last fifteen years. Most studies indicate that from a level near 4 per cent in the year 2000, the real neutral rate today is as low as 0.4 per cent. These estimates have been made by Federal Reserve research staff. The decline in the real neutral rate is not unique to the US; even in the EU we have seen a sharp decline, with the neutral rate being in fact negative. As inflation, growth and productivity have all declined, so has the neutral rate.

If these estimates are correct, given how much lower the neutral rate is today, there is a real risk the Fed overshoots and makes a mistake. The peak in the Fed funds rate should be much lower in this cycle, with fewer hikes. Will the authorities recognise this or still be wedded to the past? If the Fed were to follow a tightening path consistent with its own forecasts then by early 2019, monetary policy will turn restrictive. Given that monetary policy works with a lag of 12-18 months, any mistake on the part of the Fed will take time to be understood as well as to correct.

Another issue facing the Fed is unemployment, or rather the lack of it. At 4.3 per cent, US unemployment is already 0.4 per cent below the Fed’s assessment of the NAIRU (non-accelerating inflation rate of unemployment). If growth continues, it is not unlikely that unemployment will slip below 4 per cent. If the Fed believes in its own NAIRU calculations, at some stage the lack of labour market slack will cause a spike in inflation. The authorities need to engineer a rise in unemployment to more sustainable levels. The problem with this is that it is almost impossible to finesse a rise in unemployment. You can almost never get just a small pick up in unemployment; its dynamics are such that it is almost impossible to control. In the postwar era, in the US, whenever unemployment has increased sustainably by 0.3 per cent, it invariably overshoots, triggers a recession and rises much more. How the Fed handles the current extremely low levels of unemployment, and the need for normalisation will be a big test in the coming years. A rise in unemployment can be a trigger for the next recession.

As for imbalances built up in this cycle, commercial real estate comes top of mind. Given what is happening to Main Street retail and the structural challenges faced by their business model, retail infrastructure, especially malls, will be challenged. Commercial real estate prices are already in real terms nearly 10 per cent above their 2007 peak, having risen by more than 80 per cent since 2010. The stock of debt outstanding here is nearly $4 trillion. If, as expected, vacancy rates rise for offices, malls and other commercial properties we could see stress. However, the banks have already tightened lending standards, thus any bust should not damage bank balance sheets beyond what they would experience in a normal cyclical downturn.

Corporate debt levels are near peak, with companies using the low rates to refinance. Till rates rise, pressure will not manifest as borrowing costs are so low and access to credit so plentiful. We need to worry once interest rates start moving up.

Consumer debt to disposable income is actually very well contained, as mortgages continue to decline led by falling homeownership. On the consumer side the possible stress points are student loans and auto loans. Student loans are at an all time high, with default rates near 10 per cent. Auto loans are near their previous peak, default rates have started inching up here as well.

While there are some imbalances, there does not seem to be any catalyst for an imminent crisis.

It does not feel as if there will be a recession in the US any time soon. We probably have another 12-18 months before the economic cycle turns. However once it does, be prepared for serious pain. Investors have had a clear run for the last eight years, this period of smooth sailing is now coming to an end.