As a rule, recessions are bad news for investor portfolios. We do not expect a near-term downturn in the US economy but it is worth reviewing potential triggers. In the early 1980s, 1990s and 2000s the Federal Reserve arguably prompted three recessions by raising interest rates, in each case in response to rising inflation pressures. Could Janet Yellen’s Fed repeat history?
To be sure, the Yellen Fed has been in no hurry to increase interest rates but that was also true of the Greenspan regime in 1994 and 2004. However, it became clear – too late – that inflation was a problem. True, inflation is moderate at present but there has been a gentle upward drift in core (ex-food and energy) inflation to 2.3%.
The likely cause of any future inflation problems will be the labour market and the chart shows a couple of indicators which suggest that there is already upward pressure on wages. The black line is the 12-month change in hourly earnings; the red line is an Atlanta Fed wages tracker; and the blue line (on the right hand scale) is the compensation plans balance from the monthly NFIB small business survey.
The Atlanta Fed tracker includes employee benefits as well as cash payments. It moves roughly in line with wage inflation and seems to suggest that employers are offering extra perks to retain staff. The NFIB survey measure tends to lead earnings and has been signalling higher wage increases for some time.
This chart explains why the Fed is so set on raising interest rates. In short, wage pressures will drive Fed rate rises over the next 18 to 24 months and increase the chances of a recession ahead. However, we have to say that the threat looks distant rather than immediate.
The 2008-09 recession was started by Fed rate hikes but worsened by the overhang of sub-prime mortgage debt. Could there be a debt problem this time round?
The second chart suggests that there is still too much debt outstanding. After the financial crisis, US total debt levelled off but has begun rising again, reaching 250% of GDP in the first quarter. Comparing current levels with the 2009 peak, household debt is lower by 17.6% of GDP, government debt (federal plus state & local) up 19.9 ppts and business debt roughly flat. This provides some comfort in that governments (Orange County, Detroit and Puerto Rico aside) usually repay but it does limit the scope for a fiscal stimulus package, if the economy stumbles.
The two private debt sectors to watch are student loans and auto loans. Outstanding student loans currently total $1.26 trillion, with a frightening delinquency rate of over 11% which the New York Fed thinks is half the true rate! Auto loans totalled $1.1 trillion as at 30th June, with a much less alarming 3.5% delinquency rate but a rising proportion of sub-prime loans.
The uneasy conclusion is that the next recession and the next financial crisis are on the horizon. However, the good news is that neither looks likely in 2016 or 2017 nor will they be remotely as severe as in 2008-09.