Next recession won't be a calamity, but recovery won't be rosy either

Next recession won't be a calamity, but recovery won't be rosy either
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Whenever the economy enters a downturn, it is likely to come from the corporate sector. This is because recessions are a function of economic imbalances, and at the moment, the aggregate corporate balance sheet is being stretched compared to history.

This is not the case with U.S. households, who have a fortified balance sheet mainly because of the forced deleveraging that took place following the collapse of the housing market.

Basically, the defaulting of residential mortgages, as painful as it was, has put people in better financial shape today compared to where they were in the last decade.

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On the surface, this suggests that the next recession is likely to be much milder than the 2008-2009 recession, which experienced a record large drop in consumer spending. With consumption accounting for nearly 70 percent of GDP, it is hard to have a deep downturn without households reining in spending in a big way.

 

However, the recovery that is likely to follow the next economic contraction may be quite mild. This owes to two important factors:

One is the high probability that interest rates will still be low at least compared to post-WWII history at the time of the cyclical peak. This effectively mitigates their ability to rally much. In other words, the economy got a lot of bang for the buck when interest rates had the ability to fall from artificially high levels. 

Today, interest rates have been kept artificially low by central bankers who have pursued quantitative easing and negative interest rates. The other is the fact that the ratio of the budget deficit to GDP will be elevated, arguably mitigating the ability of the fiscal authorities to respond in an aggressive way.

Now, let us get back to the next downturn. The ratio of nonfinancial corporate debt to nominal GDP is just below its all-time record high. As of the first quarter of 2018, which is the latest available data point, the ratio stood at 45.4 percent.

This was unchanged compared to the fourth quarter of 2017 and down slightly from an all-time record high of 45.7 percent in the previous quarter. These elevated readings are troubling.

When the economy entered recession in 2001 and again in 2008, the ratio of nonfinancial corporate debt to nominal GDP was 44.4 percent and 44.0 percent, respectively.

Today’s lofty reading suggests that the corporate sector is highly leveraged and that it could be very vulnerable to higher interest rates. Pay attention Fed Chairman Powell.

In fact, one of the reasons that corporate debt is so high relative to GDP is because interest rates have been so low due to the aforementioned quantitative easing and forward guidance by the Fed.

To be sure, firms have used artificially low rates to borrow in the capital markets and only buy back a record amount of stock in the equity market. The inherent instability of debt over equity financing suggests that the next downturn could hit investment spending unusually hard. It does not have to be this way.

Fortunately, households are in much better shape. Their debt to income stands at 106 percent, which is down sharply from an all-time record high of 136 percent in the fourth quarter of 2007.

Additionally, the current ratio, which has been stable for the last three years, is basically where it was in the early 2000s at just above 100 percent. This was before the mortgage/credit/housing bubble took hold.

All is not bleak. Whenever the next recession begins, it will likely begin with the unemployment rate well under 4 percent. This should further insulate consumers.

However, because rates will be low whenever the next cycle begins and because the government’s finances may be worse, a muted policy response may lead to a muted recovery. In the interim, it would be extremely wise for monetary policymakers to proceed very cautiously in their campaign to normalize interest rates.

But this is a discussion for another day.

Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France.