It was a chastening end to 2018 for investors, as risk markets proved highly volatile in the face of an increasingly uncertain global backdrop.
Somewhat weaker economic data, peak US corporate earnings, the impact of US President Donald Trump’s trade policy and the inversion of the US yield curve have fuelled speculation of a US recession in 2020.
Critical to this debate is an understanding of where we are in the current credit cycle, and as the current economic expansion ticks into its second decade there are several factors worthy of consideration when attempting to gauge when it might come to an end.
Although there is a legitimate discussion to be had around the reliability of a flattening yield curve as an indicator of a recession, given potential distortions arising from a decade of quantitative easing, it still warrants close attention.
It appears most unlikely that a US recession hits in 2019 – although we do expect growth to slow from here.One area of concern would be its impact on the banking sector: yield curve inversion can cause a recession when banks start to tighten lending standards as maturity transformation becomes less lucrative.
For now, however, the evidence points to most banks continuing to loosen lending standards, suggesting a bank-induced growth slowdown is not an imminent threat.
Federal policy
Another area to consider is US Federal Reserve policy. As the primary driver of the front end of the curve, how Fed policy develops will play a role in dictating the longevity of the current cycle.
It is now broadly accepted that in recent cycles the Fed, to a greater or lesser degree, has overtightened interest rates.
Because of this, we would be surprised if, having learned the lessons of previous cycles and having achieved a fair amount of tightening, the Fed did not slow the pace of rate hikes.
This would relieve some of the pressure on the front end of the curve.
Looking for other indicators of where we are in the credit cycle, the health of the banking sector merits close consideration, especially given the origins of the global financial crisis. Encouragingly, the present picture is a broadly positive one.
Bank fundamentals remain strong, something that was validated by the results from the recent annual stress tests and the Fed’s Comprehensive Capital Analysis and Review process.
Asset quality remains near peak levels, capital ratios are well over minimum requirements and cost exercises have helped boost margins and earnings. Furthermore, favourable economic conditions provide a strong backdrop for the coming months.
So, if the current health of the banking sector invites a relatively sanguine response, what of the corporate sector? The third quarter earnings season in the US was one driver of recent volatility in risk markets.
Despite record earnings and revenue growth equity markets corrected as outlook statements disappointed somewhat.
On top of this were signs that Mr Trump’s trade policy is affecting sectors like automotives and technology more negatively than previously anticipated.
It is also disappointing that recent tax cuts have not really been used to improve corporate balance sheets, meaning leverage within the US corporate sector remains elevated for this point of the cycle.
Indeed, in contrast to the previous cycle, it is corporates and not financial institutions or the consumer that have seen the largest debt build-up.
Given all this, it appears most unlikely that a US recession hits in 2019 – although we do expect growth to slow from here.
However, with the build-up of debt in the corporate sector, we believe if the cycle does turn then it will be here, and not the financial or household sectors as in 2008 to 2009, that will bring it to an end.
Mark Munro is investment director of Aberdeen Standard Investments
