How this business cycle ends due to credit writedowns
About a month ago, I wrote a post on how market contagion would happen due to deteriorating credit conditions in energy high yield. And while this doesn’t necessarily lead to recession or financial crisis, it has already meant a real economy slowdown in the US. When the business cycle does end, however, the credit cycle end will be integral to that end. So I want to pick up on some signs of end of cycle distress I am seeing in credit.
First, let me review the business cycle model I am using. And this is the same model for garden variety recessions as well as for downturns exacerbated by financial panics like the one from 2007 to 2009.
Consumer spending makes up about two-thirds of the US economy, thus driving the long-term rate of economic growth more than any other variable. Therefore, identifying turning points in consumer spending patterns is critical in predicting turning points in the economy as a whole. This is why, despite the widespread claim that jobs are a lagging indicator, I focus on jobs, particularly the rate of change of workforce expansion. As I indicated last week, jobs are basically income that supports consumption and a specific growth path. And the rate of change in job formation is a leading indicator of economic growth.
Now, over the short- to medium-term, if the growth in employment and income stalls enough or even falls, the ‘shock’ to income growth causes producers to re-calculate, reduce production and purge inventories. And if this recalculation is large enough and the growth path of the economy is slow enough when the economic shock hits, we will see a concomitant impact on credit, loan losses, credit writedowns and so forth. resulting in recession.
Even in the recession that coincided with the financial crisis, this same pattern was apparent, with the economy falling into recession in December 2007, before the financial crisis became acute. The core of the recession was an economic downturn in specific economic sectors – housing and home-building – that rippled throughout the economy enough to cause an income and credit shock economy-wide that induced recession.
So in looking for turning points, we should be looking at consumers’ real hourly earnings growth and job growth before consumer spending, and consumer spending before industrial production and capital spending and corporate profits. Now, all of these measures have turned down in this cycle due to what has happened in the energy sector. And that is suggestive of end of cycle dynamics in the real economy.
However, I am particularly attuned to the credit side, as the credit accelerator’s adding to current income is what drives growth upward and then down in a cycle. Here, we are seeing credit acceleration turn to deceleration as declining loan loss provisions turn to increased provisions due in large part to the energy sector.
Here’s the Wall Street Journal last week:
J.P. Morgan Chase & Co. built up its reserves for bad loans, a shift that spotlights Wall Street’s mounting concerns about the fate of oil and gas companies.
The move to bulk up the bank’s rainy-day funds was the first in six years for J.P. Morgan, or any of its closest three rivals. It comes as struggles in the oil patch have prompted some other smaller banks to beef up their loan-loss reserves recently, and more could follow.
It’s not the absolute numbers that matter here except to the degree it predicts the magnitude of credit deceleration. What matters is that we are now entering a period of increased loan loss provisioning after an extended period of lower charge-offs and loan loss provisions.
Loan losses provisions for all commercial banks peaked at $235.8 billion in April 2010 and declined by $126.8 billion through the end of 2014. Due to the oil price collapse and the troubles in the energy sector 2015 saw the loan loss provisions shrink by a mere $2.4 billion across the entirety of the US commercial banking sector. That means that 2016 is likely to be the first year in six when loan loss provisions increase. In conjunction with the decline in the job growth rate and corporate earnings that began in early 2015, we have a major signal for an end of cycle dynamics.
Now, we could be in a mid-cycle pause. I always leave that option open as a Goldilocks scenario. But I believe the length of the decline in the job growth rate and corporate earnings before credit loan provisions started up suggests that a mid-cycle pause scenario can’t be a base case. If not, then the questions become how extensive the loan losses will be, when the business cycle ends in recession, and how deep that eventual recession will be. If you look at the financial crisis, for example, the dynamics were similar to a garden-variety recession in the initial real economy effects. It was the credit sector that exacerbated the downturn as the loss of credit created liquidity-induced distress which rippled out throughout the real economy, creating yet more credit distress that otherwise would not have occurred.
In the next downturn, if it is due to energy alone, the magnitude of the credit losses will be lower and the downturn likely less severe than the last one that was induced by housing, a much larger credit sector. However, we should also be looking at municipal debt, auto loans and student loans for other areas that could add distress once the economy turns down.
My overall take here, then, is that both real economy and financial economy data show a slowing economy that has the hallmarks of the end of the business cycle. Nevertheless, it is still unclear whether this slowing will lead to recession — and if it does, when that recession will occur or how deep it will be. I am on recession watch now though. And while I tend to think we will avoid another serious financial crisis, I also believe we are close to the end of this business cycle.
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