What are the ingredients which Suggest a Financial Crisis?

@RaoulGMI identified the following factors contributing to a crisis, before Coronavirus:

  1. Stocks: Largest Equity Bubble of All Time: (Pension Crisis & Buyback Bubble)
  2. Demographics:
    • Largest Retiree Wave, all wanting to sell stocks and bonds at the same time
    • Millennials are too poor and indebted (make 20% less than parents)
  3. Corporate Credit: Largest Credit Bubble of All Time
    • ($10 Trillion + Off balance Sheet = 75% of GDP)
  4. Student Loan Bubble:
    • $1.6 Trillion
  5. Auto Loan Bubble
    • ($1.2 Trillion)
  6. Indexation Bubble
  7. ETF/Market Structure Bubble
  8. Foreign Borrowings (Dollar Standard Bubble)
  9. Monetary Policy Bubble (The Central Bank Bubble)
  10. EU Banking Crisis
  11. A Trade War:
    • The Trade Wars “shattered” supply chains
  12. Coronavirus
    • Largest Supply & Demand Shocks of all Time


Big Picture:

Central Banks have been fighting for the last 20 years:

  • Full Scale Debt Deflation and a Solvency Crisis

Turns into:

  • A loss of confidence in the Dollar Standard and the Entire Financial Architecture

(page 29-30)

Corporate Credit, Employment And Recessions – Putting It All Together


Investment-grade corporate bonds have been a major tailwind to the economic cycle as yields continue to drop.

Treasury bond yields are falling faster than IG spreads are widening, resulting in lower borrowing costs, but a major increase in late 2018 may have triggered a change in employment.

A rise in corporate bond yields impacts cash flows, margins and, eventually, employment decisions.

Corporate bond prices (yields) are a long leading indicator that impacts the economic cycle through changes in corporate capital spending and employment.

The corporate sector is more leveraged than previous economic cycles. A recession can be triggered if the Coronavirus outbreak causes corporate rates to rise, accelerating the decline in employment growth.

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Along with money supply, building permits and corporate margins, corporate bond prices or corporate bond yields fall into the “long leading” indicator bucket, according to “the father of leading indicators,” Geoffrey Moore. Geoffrey Moore’s work found value in using the Dow Jones Corporate Bond Price Index (graphed below), but any measure of corporate bond yields will likely yield similar results. If using bond yields rather than bond prices, the indicator should be inverted as higher corporate bond yields usually translate to lower profit margins and slowing employment growth.

Dow Jones Corporate Bond Price Index:

Source: Bloomberg, EPB Macro Research

As the chart clearly shows, lead times before a recession can be quite long while lead times for recovery are more abrupt. The recovery (or suddenly lower corporate bond yields) has historically been quite helpful in restarting the hiring process and capital spending process.

From an economic cycle sequence perspective, lower bond prices or higher corporate bond yields reduce margins/profitability and have a resulting impact on the rate of capital spending and employment plans. The drop in capex and reduction in employment growth is what ultimately leads to lower income growth, consumption growth, and, eventually, a recession.

In Lacy Hunt’s most recent Quarterly Review and Outlook, he outlined Milton Friedman’s work, which explains that monetary changes (interest rates) and economic cycle impacts typically cluster around two years.

As the research of Nobel Laureate Milton Friedman documented, the typical lags between monetary change and economic fluctuations cluster around two years, confirming the importance of the two-year time frame.

A change in interest rates today may impact future projects. Still, existing investments will likely continue, resulting in a lag between the change in interest rates and the impact on more coincident economic data such as employment.

As a result of this finding, when studying interest rates, it can be valuable to use a 24-month change formula rather than a year-over-year method to more closely capture the two-year cluster.

The last point to stress before highlighting some of the more recent trends is that the level of corporate debt is at a record high relative to GDP.

Corporate Debt to GDP Ratio:

Source: Bloomberg, EPB Macro Research

Thus, similar to federal debt, there are diminishing marginal returns or reduced efficacy of each new dollar of debt. More importantly, however, smaller changes in interest rates (corporate bond prices) can have a similar or larger impact on corporate health and the resulting repercussions on overall employment.

Throughout the rest of this note, we will look at the impact of changes in corporate bond prices (yields) and the lagged relationship to employment, as well as some considerations when making a recession forecast.

Currently, corporate bond yields are still falling because Treasury rates are declining faster than spreads are widening. Lower corporate bond yields are helpful on the margin, but the late 2018 spike (two-year cluster) may have been enough to start the process of reduced employment, something very evident in recent data. If the Coronavirus outbreak causes corporate bond yields to rise and accelerates the existing decline in employment growth, a recession is very much in the cards.

Today’s rate of employment growth is insufficient to trigger a recession based on past samples. Still, when an existing downward trend is coupled with a negative shock, recession risk must remain firmly on the table.

US Corporate Sector Health Heading Into 2018

Corporate America has been plagued by anemic economic growth in this economic cycle. Masked by the rising share price of roughly 500 companies, thousands of corporations that aren’t publicly traded have been forced to operate in a low-profit growth regime.

Financial engineering has allowed publicly-traded companies to report strong earnings growth. Total corporate profits reported in the GDP report is a far more accurate, albeit delayed, data source on the real (non-adjusted) profits generated by the corporate sector.

From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.

Corporate Profits:

Source: Bloomberg, EPB Macro Research

On a five-year annualized basis, corporate profits have increased by just 2.2% with the latest year-over-year reading falling 0.3%.

Amazingly, corporate debt has increased, and share prices have soared with very little profit growth, a phenomenon exposed by persistently lower Treasury rates.

Corporate Profits Growth:

Source: Bloomberg, EPB Macro Research

Stacking together real estate debt, corporate debt, and consumer debt shows that the largest increase across economic cycles is coming from the corporate sector.

In the last economic cycle, corporate debt was only 25% of the credit market. In 2018, corporate credit increased to 38% of the total.

Corporate Sector Debt As A % of Total:

Source: Morgan Stanley, EPB Macro Research

As a result of lower profits and more debt, the leverage ratio in corporate America has surged to recessionary levels.

Importantly, the leverage ratio usually increases during a recession as profits (the denominator) fall. Morgan Stanley’s research from 2018 calls out that leverage is at an all-time high in a “healthy economy,” which highlights just how leveraged and sensitive to changes in interest rates the corporate sector has become.

Corporate Sector Leverage:

Source: Morgan Stanley, EPB Macro Research

When corporate borrowing costs rise, employment typically suffers as the increase in interest expense compresses margins.

Again, due to weak economic growth and lackluster profit growth across the entire corporate sector, margins (proxied below) have been compressing since the early stages of this economic cycle.

Lower margins foreshadow weaker employment growth and capital spending growth.

Corporate Margins:

Source: Bloomberg, EPB Macro Research

With corporate leverage at extreme levels and corporate margins already in decline, the corporate sector was particularly vulnerable to any spike in corporate borrowing costs as a result of an economic slowdown.

When the Federal Reserve embarked on a monetary tightening cycle, economic conditions globally started to deteriorate with a lag, hitting most economies in 2018 and 2019.

US corporate borrowing costs surged in late 2018 and early 2019, which triggered a more aggressive decline in employment growth and persistent weakness in capital spending growth.

Late 2018 Credit Event – Enough To Trigger A Recession?

Typically, before recessions, corporate bond prices decline (yields increase) as the Federal Reserve is raising interest rates, and the tighter monetary conditions eventually slow the economy, leading to wider corporate bond spreads.

Corporate bond prices declined three other times this economic cycle, coinciding with the three economic slowdowns before the current downturn.

The 2018 decline in corporate bond prices was larger than the previous three, a sign that economic conditions would weaken. When comparing to the past two recessionary samples, the decline in 2018 was marginally weaker than in 1999. Still, given the leverage ratio and decline in margins, a smaller decline could have a similar impact.

Corporate Bond Prices Tumble:

Source: Bloomberg, EPB Macro Research

Graphed another way, the chart below shows the 24-month change in Baa corporate bond yields.

The chart is graphed by the number of months before/after a recession with 0 on the x-axis indicating the start of a recession.

The 2018 rise in corporate bond yields was undoubtedly less than the previous three samples, only spending 14 months above 0% on a 24-month change.

Corporate Bond Yield 24-Month Change:

Source: Bloomberg, EPB Macro Research

The corporate sector is far more levered today, with weaker margins and lower trend growth as compared to the prior three recessions.

Thus it remains possible that the decline in corporate bond prices was enough to trigger a downshift in employment growth, an effort to preserve margins.

Impact On The Real Economy

Cycles in employment can be monitored separately from cycles in growth. Geoffrey Moore tracked cycles in growth, inflation, and jobs independently.

Leading indicators of economic growth turned lower very early in 2018, some in late 2017. Inflation indicators did not plunge until September 2018, and jobs growth did not inflect lower until corporate bond yields spiked in late 2018.

Cyclical employment, defined in the chart below as durable goods manufacturing, construction, and trade/transportation services, started to show rapidly-declining rates of growth.

Employment Growth Changed:

Source: Bloomberg, EPB Macro Research

If we track the change in cyclical employment growth before the three previous recessions, we can see recessionary periods begin with similar declines in cyclical employment.

Today’s current track of cyclical employment growth is currently insufficient to be recessionary based on past samples. However, if the trajectory does not flatten or inflect higher, history suggests that income and consumption growth will follow, leading to recessionary conditions.

Employment Growth Trend Relative To Past Samples:

Source: Bloomberg, EPB Macro Research

Employment growth over the next six months remains critical. If corporations continue to post weaker rates of employment growth or accelerate layoffs as a result of the Coronavirus outbreak, a recession is still firmly in play.

An existing trend of weaker growth and employment, originated by the Federal Reserve tightening cycle and deleveraging in China, exposed the economy to a negative shock.

It’s clear using the chart above how a negative shock (COVID-2019) coupled with an existing downturn in growth/employment can create a recession.

The Current Shock

The current economic shock has resulted in a widening of corporate bond spreads. Using popular credit ETFs (LQD) and (HYG), we can track the implied spread above Treasury bonds. Both investment-grade and high-yield credit spreads, particularly high yield, have been widening materially in the past several weeks.

Investment-Grade / High-Yield Corporate Spreads:

Source: Bloomberg, EPB Macro Research

Luckily, however, corporate yields are a function of Treasury rates plus a spread.

For investment-grade bonds, Treasury rates are still declining faster than spreads are increasing, resulting in lower investment-grade bond yields.

High-yield bonds, however, are starting to see higher yields, a firm negative for corporate margins and future employment.

Investment-Grade / High-Yield Corporate Bond Yields:

Source: Bloomberg, EPB Macro Research

The current slowdown in employment growth, specifically cyclical employment growth, is severe and can be seen in many economic data points. If leading indicators of economic growth were turning higher, however, and cyclical employment growth started to increase, the economy may very well avoid a recession.

The negative shock of the Coronavirus has likely caused employment plans to freeze, irrespective of any increase in borrowing costs.

If the Coronavirus continues to cause a sell-off in risk assets and spreads start to widen faster than Treasury rates decline, corporations will be faced with higher borrowing costs at a time when economic growth was on shaky ground to being with.

Employment Growth Trend Relative To Past Samples:

Source: Bloomberg, EPB Macro Research

Should an increase in borrowing costs accelerate the decline in employment growth, and the black line in the chart above drifts into the yellow circle, a recession will be tough to avoid.

Clearly, a call for a recession is premature, and my economic outlook has zero forecasts concerning the virus or any predictions regarding a conclusion.

Rather, when constructing an allocation to weather a shock, we must be mindful of the current state of the economy and the susceptibility to a recession from a negative event.

Currently, a recession is not imminent based on the data above. Still, the situation can evolve quickly, and the economy is far from immune to a shock in its current state.

Keys To Watch and Outlook

The increase in corporate bond yields late in 2018 was small in relation to other recessionary periods. Still, given

  • the level of corporate leverage,
  • anemic profit growth, and
  • weak economic conditions,

a smaller increase can have a more significant impact.

Employment growth has been in a downtrend since that late 2018 period, contributing to weaker rates of consumption growth seen in recent reports.

The economy is not imminently vulnerable to a recession, but that can change in a matter of weeks. The impact on employment is the key to watch when judging lasting recession risk.

Moving forward, if the current shock causes employment growth to suffer, already in a fragile state, recessionary conditions will be tough to avoid.

An acceleration in corporate layoffs will be exacerbated by higher borrowing costs, making credit spreads and bond prices a vital signal.

Given the susceptibility to a recession pending a worsening of conditions, investors should consider an added layer of protection should this negative shock take a turn for the worse.

If conditions worsen or simply do not improve for several weeks, a recession may be difficult to avoid, mainly due to the initial conditions before the shock began.

If the economy does tumble into a recession, risk assets are highly exposed, and a continued overweight allocation to Treasury bonds and gold will likely offer the best protection.

The model portfolio at EPB Macro Research continues to have an overweight exposure to Treasury bonds and gold.