Everything Is Going Wrong All at Once for U.S. Banks

Epidemic triggers risks from low interest rates, slow loan growth and sliding stock and energy prices

Add together some of the biggest challenges U.S. banks weathered in the dozen years since the financial crisis, and you get an idea of how bad the coronavirus epidemic could be for them.

A decade ago, banks persevered through a recession and widespread loan defaults. Until 2015, they endured years of ultralow interest rates and slow loan growth that pressured their profitability. In 2015 and 2018, banks survived selloffs in the stock market. In 2016, the industry came through a collapse in energy prices with a few bruises, but no big busts.

Now, banks face all those threats simultaneously. Many of their businesses mirror economic activity, so falling growth and rising unemployment can dent their profits. Sharp drops in asset prices can sap their investment-banking and trading revenues as deal activity and investors pause.

Banks entered the year better capitalized and less reliant on flighty, short-term funding than they were on the eve of the financial crisis. But their earnings likely will suffer.

Fears of the impact of the coronavirus have erased all of the “Trump Bump” gains that the KBW Nasdaq Bank Index and four of the six largest U.S. banks had notched since the 2016 presidential election. The KBW index fell more than 10% Thursday morning as investors bet that new travel restrictions and the possibility of more rate cuts from the Federal Reserve will continue to hammer the financial sector.

Here is a look at how banks could fare in a coronavirus-related slowdown:

Lower Lending Revenue

Around two-thirds of banks’ revenue last year came from interest earned on loans and securities, according to data from the Federal Deposit Insurance Corp. The rates banks charge on some large categories of loans, including commercial and industrial lending and credit-card balances, are tied to benchmarks that have fallen in recent weeks. That threatens to crimp banks’ net interest income.

For instance, a reduction of 1 percentage point in both short- and long-term interest rates translates to $6.54 billion in lost interest income in 2020 for Bank of America Corp., BAC -9.53% or roughly 7% of its annual revenue, according to estimates from Credit Suisse Group AG. Bank of America is an outlier, but the average big U.S. bank will face a 2% hit to revenue from a drop in interest rates of that magnitude, according to Credit Suisse.

Falling Loan Growth

Banks might also struggle to make up on loan volume what they are giving up in terms of loan yields. Throughout 2019, businesses and consumers showed a willingness to borrow, and loan balances at all U.S. banks at the end of the year were up 3.6% from their levels at the end of 2018, according to FDIC data.

More recently, fears of the coronavirus weighed on businesses’ decisions to invest and expand, especially in sectors such as travel and hospitality and in industries that depend on global supply chains. Commercial and industrial loans increased by less than 1.5% each week in February compared with the same period last year, according to data from the Fed. In February 2019, commercial and industrial growth exceeded 10% each week.

Consumers have borrowed from banks at a higher pace than corporations have since the start of the year, but have started to flag in recent weeks. Since late January, banks’ consumer-loan growth has plateaued at just under 6%, according to Fed data.

Consumer Crunch

The prospect of scores of consumers missing work and forfeiting paychecks also bodes poorly for many of the loans banks already have on their books. Delinquencies and defaults on mortgages, auto loans, credit cards and other forms of consumer borrowing tend to rise and fall with the unemployment rate, and any prolonged period of joblessness likely will mean that borrowers fall behind on their loan payments.

Banks have been more conservative in extending credit to consumers since the financial crisis, and the industrywide loan-loss rate is well below its long-term averages and just 0.18 percentage point above its record low in 2006, according to analysts at Barclays BCS -14.82% PLC. But things can worsen quickly: Banks have been reducing the reserves they have set aside to cover potential defaults in recent quarters, even as defaults on certain loan categories have been rising, according to FDIC data.

Even if consumers keep paying back their loans, their spending on luxuries such as dining out and vacations is likely to fall, decreasing revenue that banks earn on those kinds of credit- and debit-card transactions.

Not Out of Energy

Many of banks’ corporate borrowers will also face difficulties making loan payments in a worsening economy, especially those in the energy sector. A steep decline in oil prices this week means oil and natural-gas companies will have less money coming in to meet existing debt payments and a less valuable asset in the form of energy reserves that they will be able to borrow against.

If energy prices stay at this level, loan losses in banks’ energy portfolios would notch a “notable uptick,” analysts at KBW wrote in a note on Monday. The four largest U.S. banks have $65.5 billion in exposure to U.S. oil-and-gas companies, and loans to such companies account for more than 10% of overall portfolios at several regional U.S. banks, according to KBW.

Markets

Revenue from Wall Street businesses such as investment banking and trading account for one of banks’ biggest sources of fee income, and both are sensitive to the impact of the coronavirus. Since the start of the year, reluctance from corporate chiefs to pursue deals has driven global mergers-and-acquisitions volume down 28% from this point in 2019, according to data from Dealogic. Citigroup Inc. C -14.83% is expecting investment-banking fees to fall in the first quarter, finance chief Mark Mason said at an investor conference Wednesday.

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Volatile markets and big swings in stocks, bonds and commodities kept banks’ trading desks busy during the first quarter, but fees from that business likely won’t be enough to offset weakness elsewhere. Banks employ fewer traders today than they did during the financial crisis, and with more trading moving to electronic venues, some fees have come down. Mr. Mason said Citigroup’s trading revenue was expected to increase “in the mid-single-digit range” in the first quarter, even though trading volumes rose by much more.

Corporate Credit, Employment And Recessions – Putting It All Together

Summary

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.

Two-Thirds of U.S. Business Economists See Recession by End-2020

Two-thirds of business economists in the U.S. expect a recession to begin by the end of 2020, while a plurality of respondents say trade policy is the greatest risk to the expansion, according to a new survey.

About 10 percent see the next contraction starting in 2019, 56 percent say 2020 and 33 percent said 2021 or later, according to the Aug. 28-Sept. 17 pollof 51 forecasters issued by the National Association for Business Economics on Monday.

Forty-one percent said the biggest downside risk was trade policy, followed by 18 percent of respondents citing higher interest rates and the same share saying it would be a substantial stock-market decline or volatility.

Is Trumponomics working? Not really.

So is Trumponomics working? With one significant caveat, the answer is no. For one thing, Trump’s trade policy is turning out to be worse than expected. For another, the growth surge mostly reflects a temporary sugar high from last December’s tax cut. Economists are already penciling in a recession for 2020.

.. At a time of toxic inequality and declining intergenerational mobility, inheritance taxes ought to be increased, but Trump cut them. However, the reduction in the corporate tax rate, coupled with incentives for businesses to invest more, has boosted spending on R&D, information technology and other machinery. Extra investment should make workers more productive. It might even shift U.S. growth to a higher trajectory.

.. you can’t rule out the possibility that the Trump investment incentives are hitting the economy just as a new wave of IT innovations is ripe for deployment.

.. The question is whether the expected productivity boost will outweigh the drag from the tax cut’s other consequence: a huge rise in federal debt.

.. The extra $1 trillion or so of federal debt will have to be serviced: Today’s sugary tax cuts imply tax hikes in the future. Likewise, the corporate investment incentives are temporary: They may simply bring investment forward, depriving tomorrow’s economy of its tech caffeine jolt.

.. many Wall Streeters expect a recession once the sugar high dissipates. The Tax Policy Center estimates that gross domestic product in 2027 will be the same as it would have been without the tax cut.

.. There will be no growth to compensate for extra inequality and debt.

.. And that is without considering the harm from Trump’s trade wars. In Europe, Trump has browbeaten U.S. allies and reserves the right to beat them up further; the only “gain” is a discussion of a new trade deal that was on offer anyway before Trump’s election. In the Americas, Trump has arm-twisted Mexico into accepting a new version of NAFTA that is worse than the old one, and demands that Canada sign on.

.. But the greatest damage stems from Trump’s trade war with China. His opening demand — that China abandon its subsidies for strategic high-tech industries — was never going to be met by a nationalistic dictatorship committed to industrial policy.

.. His bet that tariffs will drive companies to shift production to the United States is equally forlorn. If manufacturers pull out of China, they are more likely to go elsewhere in Asia.

And even if some manufacturing does come to the United States, this gain will be outweighed by the job losses stemming from Trump’s tariffs, which raise costs for industries that use Chinese inputs.

.. In short, Trump isn’t helping the American workers he claims to speak for. Instead, he is battering the rules-based international system that offers the best chance of constraining China.

.. do not be surprised if the populists are temporarily popular: Popularity is what they crave most, after all. But recall that, everywhere and throughout history, the populists’ folly is unmasked in the end.

Growth Seen Hitting 3% in 2018, But Risks to Outlook Mount After This Year

After 2018, economists in Wall Street Journal survey fret about fading fiscal stimulus, higher Fed rates and trade tensions

“The tax cuts and jump in federal spending will keep the economy buzzing for another 12 months,” said Bernard Baumohl, chief economist of the Economic Outlook Group. “Beyond that, however, I expect to see dark clouds forming that would signal a recession is near.”
.. Mr. Baumohl isn’t alone in a dour outlook after the boost from last year’s tax cuts begins to fade and because rising tariffs between the U.S. and its trading partners could lead to repercussions for the economy. Businesses that were enthused about the tax relief could hold off from hiring and investing in the face of trade uncertainty, several economists said.
.. The average forecast for growth in 2019 was 2.4%, little changed in recent months. By 2020, the average forecaster projects economic growth will slow to 1.8%, down from estimates earlier this year of 2%.
.. Inflation, as measured by the consumer-price index, is forecast to remain above 2% through 2020
.. While the immediate outlook for the rest of 2018 is strong, economists see an 18% chance of a recession beginning in the next 12 months. Those are the highest odds since President Trump’s election 21 months ago.

.. The economists in the survey placed the odds of a Nafta pullout at about 29% and the odds of auto tariffs at 31%.

What Will Cause the Next Recession? A Look at the 3 Most Likely Possibilities

The expansion is nine years old. An ill-timed end of fiscal stimulus, a corporate debt bubble and the trade war are the things that could most easily end it.

But at the same time, mainstream macroeconomic models have the economic lift from tax cuts fading sometime between 2020 and 2022. That means the Fed could be raising interest rates to slow the economy just as tax policy is also working to slow the economy.

Both affect the economy with unpredictable lags, so it could prove hard for the Fed to set policies that can prevent both overheating in 2019 and 2020 and a downturn in 2021 and 2022.

.. Ben Bernanke put it more colorfully at a conference in June. The stimulative benefit of the tax cut “is going to hit the economy in a big way this year and the next year,” he said. “And then in 2020, Wile E. Coyote is going to go off the cliff.”

.. Corporations have loaded up on debt over the last decade, spurred by low interest rates and the opportunity to increase returns for shareholders.

.. The rise in debt loads overseas, especially in emerging markets, is even greater

.. Essentially, businesses have been in a sweet spot for years, in which profits have gradually risen while interest rates have stayed low by historical measures. If either of those trends were to change, many companies with higher debt burdens might struggle to pay their bills and be at risk of bankruptcy.

.. The 2020 train wreck narrative could intersect with the corporate debt boom. If inflation were to get out of control and the Fed raised interest rates sharply, companies that can handle their debt payments at today’s low interest rates might become more strained. Moreover, with federal deficits on track to rise in the years ahead, the federal government’s borrowing needs could crowd out private borrowing, which would result in higher interest rates and even more challenges for indebted companies