Wednesday, November 06, 2019

Moody's Analytics Economist Says Probably No Recession But Maybe Not

Mark Zandi, Chief Economist at Moody’s, gave a talk entitled the Two-Handed Economist.  He said that my task is to give you the horizons for the economy.   

The Bankruptcy Forecast
He said we currently have a good economy.  Bankruptcies are steadily declining.  Personal bankruptcies maxed out at 1.5 million during the financial crisis; today they are down to 750,000 per year.  At the  peak of the financial crisis, there were  60,000 business bankruptcies per year; now we are down to 20,000.  He said that we’ve hit bottom and  he would expect both personal and business bankruptcies to increase.  Business bankruptcies will rise substantively greater than personal bankruptcies because personal households have done a better job of deleveraging.   Personal bankruptcies will increase but relatively modestly.   Non-financial corporations have now substantially levered up and underwriting has weakened.  Mr. Zandi said, that is a prescription for financial problems when the economy does not cooperate.   He told the bankruptcy professionals in the room that "going forward you will be a lot busier."

Will There Be a Recession?

He said that the most likely scenario is that we avoid an economic downturn in the next 12-18 months, but the economy will struggle.   Recession risks are high.  If I am wrong we will suffer an economic downturn next year.   

 He then outlined five areas he would cover:

What Are the Odds of a Recession?

Mr. Zandi said that recession odds are pretty close to even.   The bulk of world is in slowdown phase.   Real GDP in the U.S. was growing just over 3% after being juiced by tax cuts.  Now, it's down to 2%.  Once growth slows below 2%, the economy struggles to create enough jobs.   It is a self reinforcing negative cycle.  Once unemployment starts to increase that’s a real problem.  Unemployment is low before every recession.   

 An inverted yield curve where long term interest rates are lower than short term rates is one of the indicators of a coming recession.  He said that based on the unadjusted numbers, there is a 70% chance of a recession.  However, he said that the adjusted number was 43%   The reason for this is that there are currently negative interest rates in foreign countries.  That means that capital is flowing into the U.S. and is driving down long-term rates.   As a result, it is necessary to adjust for the bias.  

What Could Go Wrong?

Mr. Zandi presented a risk matrix of factors which could lead to a recession.   Removing the Fed Chair would have a severe effect but is unlikely to occur.   On the other hand, a manufacturing recession is likely to occur but would have limited impact.    The most likely severe impact on the 

economy is an escalation in the global trade war. There are two key links between a trade war and a recession.  The first is the cost of tariffs.  Presently there are $70-80 billion per year, which is equivalent to 0.4% of GDP.   In contrast, the tax cuts were $200 billion.   Next year, the cost of tariffs will increase to $130 billion.  Referring to tariffs, he said, "That’s a tax.  Someone’s got to pay it.He said that the other link is the uncertainty a trade war  creates. It undermines business sentiment.   Business wonder whether the tariff will be 10or will it be 25?  Businesses can go to the Department of Commerce and make a pitch as to why they should be exempt, which he described as crony capitalism at best.  He noted that there is currently flat business investment and that hiring has pulled back. He concluded, "My assumption is that the President will connect all of these dots."  He said he expected the President to make a deal with the Chinese so that businesses feel confident enough to hire.  


 What is the Road to Recession?

Usually when the yield curve inverts, there is a recession in one year.   The yield curve inverted in May 2019 which suggests that a recession is likely by Summer 2020.    When the yield curve is positive, banks can make money.   If they can make money,  they will lend.   If the cost of money is more than they can lend it at, they won't extend credit.   While too much credit is bad and too little credit is bad, too little credit after too much credit is worse.   Firms have leveraged up and will need more money to refinance.  If they come looking for money and banking system is not lending that’s a problem.

He predicted that if there is a recession, it will occur at noon on June 20th 2020.
The next indicator to go is the stock market. The stock market has predicted nine of the last five recessions according to economist Paul Samuelson.   The stock market can signal a recession anywhere from a couple of months to a year ahead of time.  A booming stock market is not a protection against a recession as shown by the fact that the stock market was at a record high in October 2007.   
Consumers are on edge.  There has bee a decline in consumer confidence.  Consumers are usually the last to figure it out.  If consumer confidence falls for 2-3 months, we’re there.   Google searches for "recession" are trending up.  Consumers are not in the bunker yet, but they have their hand on the bunker door.

What will the Policy Response Be?

Policy makers are working hard to avoid a recession.  The Fed has cut rates three times.   Having rates  at 1.5-1.75% is helping.  Currently, there is a 4% fixed mortgage rate.   When rates go below 4%, it brings light back to the refinance market. However, there is a limit to how much the Fed can cut rates.  There will be a point in time when investors say oh my God, we are closing in on 0%.  If they keep cutting rates they will run out of room.   He said that is getting closer than you think. There is already a lot of debt with negative yield.   If we’re in a recession,  we’re going negative.   It’s going to be hard for the Fed not to push short term rates into negative. We are going into an election year.  In an election year, it is hard for Congress to pass sweeping measures to help the economy. While an infrastructure package is something that could get done, it won’t benefit anyone until 2021.

How Bad Will It Be?

In a typical recession, unemployment goes to 6-7% We've been through this ten times since World War II.    Housing and commercial real estate will lead the way.  The economic indicators suggest typical economic downturn.  However, Mr. Zandi is not so sure. There is currently  $2.7 trillion in debt owed by  highly leveraged companies.  At the peak of the subprime mortgage crisis, there was  $2.7 trillion worth of subprime mortgages.  Because the economy is bigger today, the impact is not as severe.

However, there is a lot of bunching at two levels of bond debt.  There is a lot of bunching of BAA bonds, which is one notch below investment grade, and B3, which is one notch above C.  There is  leveraging right up to those lines.  If bonds drop below BAA, fiduciary investors can no longer hold them in their portfolios.  If bonds drop to C, they get kicked out of Collateralized Loan Obligations for being junk bonds.  
 Another risk is in the shadow system, that is, mortgages originated originated by nonbanks.  The   shadow system is big and it does not have the same level of regulation as banks.  Many of the loans being originated by non-banks are sold to GNMA and are loans made to low income and first time homeowners.   
Nonbanks rely on big banks for funding.   In a recession, lines of credit may be closed and repo market may shut down.  This means nonbanks will get cut out of funding.  If they can’t make loans, the housing shuts down.   This is not about capital, is a threat from a liquidity event.  The only way you get out of a liquidity event is for the Fed to enter the system.
 By now, it should be clear why this presentation was titled the Two Handed Economist.  On the one hand, Mr. Zandi thinks we are likely to avoid a recession.   On the other hand, there are triggers out there which might lead to a recession.  On the one hand, economic indicators suggest that any recession could be mild.  On the other hand, risks pertaining to leveraging and liquidity mean that things could go seriously off the rails.   The only thing that is certain is that we are in a time of uncertainty.

Author's Note:  I tried to capture Mr. Zandi's words are closely as possible.  In some places, I missed a word or a phrase and filled in what I thought was an equivalent word or phrase.   This is similar to what artificial intelligence would do except that I am using my actual intelligence to fill in the gaps. I apologize in advance if I made any errors in presenting Mr. Zandi's reasoning.

I also apologize that I was taking pictures of Mr. Zandi's slides from an angle so that the photos are a bit slanted and it looks like they were drunk.

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