What the Coming Recession Will Look Like

The Australian Financial Review2022-12-16

With US equities getting pounded overnight – down some 2.5 per cent – and the S&P 500 slipping below 4000 points again as a result of renewed fears of an interest rate-led recession, it is instructive...

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udf
2022-12-16
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2022-12-16
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And now central banks around the world are increasingly acknowledging that the record rise in interest rates that they are imposing on unwitting borrowers in response to the biggest inflation crisis in 40 years will inevitably force the global economy into a serious downturn.While all the macro data flows continue to deteriorate sharply, the central bankers have to date wanted to keep their foot on the throat of the inflation genie. Investors have, therefore, had to grapple with consistently hawkish rhetoric from the monetary policy mandarins while recognising the practical reality that we are rapidly approaching peak terminal cash rates.In the case of the US Federal Reserve, this was bumped up during the week from the Fed’s prior estimate around 4.6 per cent to 5-5.25 per cent. It is remarkable to think that financial markets in December last year were only pricing in a maximum Fed policy rate of just 1 per cent.So what will the coming high inflation recession look like? Coolabah’s chief macro strategist, Kieran Davies, has done the heavy lifting, studying all US downturns back to the 1950s. His first finding is that low inflation recessions tend to be shorter at, on average, only eight months, compared to high inflation equivalents, which are longer at about 11 months. The worst recessions are those characterised as financial crises, which typically last 18 months.In both low and high inflation contractions, unemployment ordinarily increases by a touch more than 3 percentage points, although the starting point this time around is characterised by unusually low jobless rates. In Australia, the unemployment rate is only 3.4 per cent.Reflecting the fact that high inflation recessions warrant larger increases in interest rates, the rise in unemployment during these episodes creates almost double the spare capacity (or job losses) compared to recessions experienced during low inflation periods.This extra labour market slack means that core inflation falls much further in a high inflation recession: specifically, by about 4.2 percentage points relative to the 1.7 percentage point decline registered during low inflation retrenchments.And the trough in core inflation normally takes much longer to materialise after a bout of high inflation. Davies finds that in these cases, inflation does not hit its nadir until about three years after the start of the recession, which is double the 18-month delay observed in low inflation contractions.Rates turnaroundOne key question on everyone’s lips is when the central banks will start easing rates. This normally occurs about four months before a recession begins. But in high inflation shocks, central banks delay longer than in any other type of downturn, and do not normally cut until the recession actually commences.AdvertisementA silver lining is the fact that the peaks in interest rates in high inflation periods are usually short at only one month, compared to the five months observed in low inflation recessions. Again, this time might be different because the central banks have all warned markets not to expect immediate cuts once the peak is obtained, due to the unusually elevated core inflation rates.Whereas government bond yields have historically rolled over about three months before a recession starts, in high inflation shocks they do not normally do so until one month after the recession begins.US equities have typically fallen by a chunky 23 per cent in a high inflation recession, which is materially larger than the 15 per cent draw-down experienced during low inflation contractions.Interestingly, there is clear evidence that the sharemarket lags the bond market in this respect. Whereas government bond prices start rising (and yields decline) at the start of a high inflation recession, US equities do not normally trough until about half a year after the recession begins.ValuationsOf course, one important difference this time is valuations. In cyclically adjusted terms, the S&P 500’s price/earnings multiple touched its second-highest level ever since the 1880s – around 38 times – in December 2021. The only time it had been more elevated was at the peak of the tech boom in 2000. The median and average cyclically adjusted price/earnings ratios have been 16 and 17 times respectively since the 1880s.Even after the recent decline in US stocks, the cyclically adjusted price/earnings ratio looks massively overvalued at 28 times right now. And when we dissect the data to focus on episodes where US core inflation is above 6 per cent, we find that the S&P 500’s cyclically adjusted price/earnings ratio tends to decline to around 5-15 times (or less than half its current multiple).Zombie firmsAnother unusual feature of this cycle is the huge explosion in companies that have become addicted to cheap debt, and yet which are not generating enough profits to service the interest repayments on these obligations. Central bankers define these “zombie” firms as companies that have had earnings that are insufficient to service their interest repayments for three years in a row.Over the last decade, our systems have documented an explosion in the share of listed companies that fall into the zombie category, which globally has jumped from roughly 5-7 per cent of firms to around 12-15 per cent. And this was before the recent interest rate increases kicked off.We further find that the industry sector with the highest proportion of zombies in Australia is real estate, including construction, residential developers and commercial property, which is one reason why banks do not normally lend much to these companies. They have instead been forced to seek finance from non-bank lenders that charge higher interest rates in exchange for taking on the risk that these zombies default on their debts.The looming global recession has all the makings of a mega default cycle that will see many zombies wiped out in both the corporate and household sectors. The last time we had this sort of cathartic capitalistic clearing of the dead-wood in the economy was the 1991 recession. None of the current crop of non-bank lenders were in business back then.We know from the RBA’s sobering analysis that almost 15 per cent of all borrowers will have negative disposable income if Martin Place lifts its cash rate to 3.6 per cent (it is currently 3.1 per cent), which will trigger a substantial increase in currently ultra-low mortgage default rates.And this will be exacerbated by one in four borrowers switching in 2023 from fixed-rate home loans set in 2020 and 2021 at rates of only 1.75-2.25 per cent to radically higher variable-rate loans charging between 5-6 per cent.House pricesOver the three months to December 15, Aussie house prices have been falling at a 13 per cent annual rate based on CoreLogic data. And the pace of these declines has not really changed in the last couple of months. The worst performing market is Brisbane, where house prices are crashing at a 19.6 per cent annual rate. Sydney prices are falling at a 15.5 per cent annual pace, down from the 20 per cent plus annualised losses observed in the middle of the year. The value of bricks and mortar in the more modest Melbourne market is sliding at an 11.1 per cent annual rate.The cheapest of the big cities, Adelaide and Perth, continue to outperform, with only very small declines thus far. Of course, the more the RBA raises rates, the worse this crash will get. And the RBA is rail-roading towards another increase in February unless it comes to its senses.In terms of the cumulative or total house price declines, the five capital city index has fallen 8.3 per cent and is 55 per cent along the way to the lower bound of our October 2021 forecast for a total peak-to-trough decline of 15-25 per cent. In Sydney, home values have slumped more than 12.1 per cent. Brisbane is down almost 9 per cent followed by a circa 8 per cent loss in Melbourne.When most asset prices eventually start stabilising in 2024, we are unlikely to get much of a bounce, given interest rates may remain structurally much higher than they were before this inflation shock arriving. Future growth could be more dependent on incomes rather than the interest rate reductions that have driven asset prices since the early 1990s.","kind":"highlight","is_publish_news":true,"is_publish_highlight":true,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":9928989305,"gmtCreate":1671166135108,"gmtModify":1676538502645,"author":{"id":"4133221123928602","authorId":"4133221123928602","name":"udf","avatar":"https://community-static.tradeup.com/news/default-avatar.jpg","vip":1,"crmLevel":1,"crmLevelSwitch":0,"idStr":"4133221123928602","authorIdStr":"4133221123928602"},"htmlText":"[Surprised]&nbsp;","listText":"[Surprised]&nbsp;","text":"[Surprised]","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":2,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9928989305","repostId":2291801459,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9928932064,"gmtCreate":1671162398258,"gmtModify":1676538502038,"author":{"id":"4097476142152970","authorId":"4097476142152970","name":"DarkFate","avatar":"https://static.tigerbbs.com/a22f6ff84fe185b6d3ad31b8673302d8","vip":1,"crmLevel":6,"crmLevelSwitch":1,"idStr":"4097476142152970","authorIdStr":"4097476142152970"},"htmlText":"Like&nbsp;","listText":"Like&nbsp;","text":"Like","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":2,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9928932064","repostId":2291801459,"repostType":4,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"}],"isCommentEnd":false,"newsSizeData":{"likeSize":45,"commentSize":2,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.30.2","shortVersion":"4.30.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2291801459"}