With 2015’s rather modest gain for the S&P 500 Index of 1.38%, we can nevertheless state that the markets have generated positive returns for seven consecutive years, albeit by the narrowest of margins. After such a prolonged bull market for stocks, accompanied by broad economic improvement, we would normally start to look for a top of the business cycle and question equity valuations. And with the rather auspicious start we’ve seen to 2016, this seems like a very good time to do just that and analyze the likelihood of a US recession this year.
Generally, recessions in the US are engineered by the Federal Reserve through tighter monetary policy to prevent; 1) unacceptable levels of inflation (generally taken to be inflation in excess of the 2.0% stated target) and, 2) to discourage credit bubbles.
In respect to the first condition for tighter monetary policy, that being inflation running hotter than the stated 2.0% target, the US economy simply is not experiencing this kind of inflation. The most common measure of inflation (CPI – Consumer Price Index) has been completely benign throughout this seven year expansion averaging a mere 1.4% annualized. Other measures of inflation have been equally benign as well. Consequently, if the US does experience a recession any time soon, it likely won’t come from price inflation and associated higher interest rates.
On the second condition above, that being retarding credit bubbles, some further analysis is required. After paying down debt at an incredibly fast pace over 2008-2009, consumers have begun borrowing again with consumer credit levels as a percentage of consumption at very high levels. I am concerned that were interest rates to rise at the consumer level, for instance the prime interest rate and its various derivatives, US consumption could falter. On the other hand, however, consumer credit levels are within historical norms when compared to the average consumer’s income. In fact, if wage gains do finally gain some upward traction, consumers could assume higher absolute debt levels. The best we can say in respect to the sustainability of consumer level debt is that we’re seeing mixed indicators.
Corporate debt levels look somewhat similar in the sense that corporations have taken on more debt, however, the additional debt appears to be manageable. Over the last seven years, numerous companies have taken advantage of historically low interest rates and increased their debt levels. The 1000 largest US non-financial companies raised their debt levels by $1.2 trillion (21%) since 2008. However, much of the debt raised was simply trading equity for debt through stock buy-backs. Once interest rates move higher, I would expect many of these firms to reverse that capital position (trade their debt for equity). In addition, even with this additional debt, the average debt to capital ratio for these 1000 firms rose from 41% to a still very manageable 45%.
Where the debt levels are becoming a major concern is with numerous distressed oil and gas companies. In the event that energy prices do not improve this year, I expect many of the more distressed firms in this industry will default, or hopefully restructure, their debt positions. Notwithstanding the distress that debt default reeks on individual operators and their employees, the bigger macroeconomic issue is the impact these defaults would have on the banking system and the broader economy. By my estimate, approximately $300 billion of debt issued to the energy industry may be at risk for default or restructure. This debt is issued to approximately 40% of the US energy companies in operation that have debt outstanding as of the most current data, which was 9/30/2015. With the continued slide in energy prices over the last 4 months, that ratio has only gotten worse.
My sense is that, while $300 billion is a huge figure, it is also a manageable figure as it is most assuredly underwritten by dozens of commercial and investment banks. As these firms have been forced to dramatically increase their capital in recent years, such a wide scale and presumably rolling sort of default should not cause much more than one-time charges against these banks reserves. Consequently, the biggest threat to the credit markets is very likely a manageable situation.
Consequently, we do not believe the US economy is headed for a Fed-induced style recession any time soon. Although the Fed did raise the Fed Funds rate in December, we believe that in the face of falling interest rates around the world, the Fed will have no choice but to sit pat this year on interest rates.
Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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