Anticipating the Inevitable: When Will the Economic Expansion End?
by Dexter Van Dango Monitor 100 2018
Monitor has reported on six U.S. recessions during its 44 years in print. On the wings of the second-longest economic expansion in U.S. history, Dexter Van Dango asks the question lingering in the back of our minds: When will the next recession hit?
The idiomatic phrase “waiting for the other shoe to drop” is attributed to tenement dwellers in New York City in the early 1900s who lived in identical shotgun apartments stacked with bedrooms above bedrooms on each floor. When a resident was awakened by the sound of an upstairs neighbor dropping a shoe on the wooden floor as he got into bed, she had no choice but to wait for the other shoe to drop before she could go back to sleep.
There have been six recessions since the launch of Monitor in 1974. The Great Recession lasted from December 2007 to June 2009. Nine years have passed since the current economic expansion began, and it now ranks as the second longest in U.S. history. The economy is growing, jobless claims are at an all-time low and optimism seems to prevail and is expected to continue for the foreseeable future. Despite the rosy outlook, those who have been around for a while know there will be a down cycle — there always has been. We’re waiting for the other shoe to drop.
Each month the Wall Street Journal surveys more than 60 economists on more than 10 economic indicators. Results of the survey reported in mid-May included predictions on the economy, including opinions about when the current expansion will most likely end. Interestingly, 58.8% of respondents predicted the end will come in 2020, while 21.6% guessed 2021. Both 2019 and 2022 received 7.8% of the vote, and only 3.9% said after 2022. Which factors went into these considerations? I wonder if two years out just feels right. If the same survey were taken in 2016, would it have predicted a recession for 2018?
Insights from Industry Leaders
I contacted a group of industry veterans to ask, “What is your take on when the next recession will hit, and what would your speculation be as to the root cause?” The first to respond was Tom Depping, CEO at Ascentium Capital: “I would expect [the] next recession in 2020 or 2021. The root cause will be increasing budget deficits and increasing cost to fund the budget deficit due to rising interest rates.”
Depping’s response makes sense to me. As the economy overheats, the Fed raises rates to slow inflation and, in doing so, increases the cost of servicing the out-of-control U.S. national debt. Congress keeps kicking the can down the road by lifting the debt ceiling but doesn’t address the root cause — revenue deficits. The national debt is a big drag on the economy. A prolonged period of low interest rates has, for the most part, hidden the threat. But rising rates will have a negative effect on both the deficit and national debt.
Goldman Sachs Chief Economist Jan Hatzius recently predicted the deficit to grow to $2.05 trillion (7% of GDP) by 2028. And the Congressional Budget Office projects total national debt could rise to equal GDP in the next decade, a level not seen since World War II.1 Unless we get the deficit under control, the national debt will be a major contributing factor to the next recession.
My next reply came from Jud Snyder, president at BMO Harris Equipment Finance, who wrote, “My short answer to your question is that we are definitely heading into something, my guess would be 12 to 18 months out. The only thing that I could see accelerating that would be an ‘event’ — global terrorism, geo-political or other. Things are good right now, but, as we’ve seen in the past, [things] don’t take long to soften or deteriorate once the cycle begins.”
In speculating that the downturn will occur in 12 to 18 months, Snyder predicts the expansion will end in 2019, a full year earlier than a majority of the economists surveyed by the Journal. Snyder provided some color on root causes for the downturn, identifying three concerning factors that echo the past:
Banks and finco’s chasing yield and moving further down the risk spectrum without being properly compensated. More and more deals are going off at spreads that are unsustainable while deals are being done with covenant lite structures, longer tenors, weaker collateral positions, etc.
Rise of the fintechs. This is old news, but didn’t we learn in 2008 that if you bundle a bunch of B- credits and call it AAA, it still performs like B- credit in a downturn? It’s beyond me that deals that banks won’t touch are done by fintechs on credit scored models and then sold to banks and life [insurance companies] who happily buy the paper as securitizations or portfolios.
Interest rate pressures on borrowers. We’ve been living through a seven- to 10-year period of incredibly low rates. When (not if) rates rise, how many business and commercial borrowers will struggle with higher demands on cash flows due to higher borrowing costs? This will cause delinquencies in the lower end of the commercial borrowing sector.
Dr. James Johnson, presidential teaching professor of finance at Northern Illinois University, provided a third response. In addition to teaching, Johnson is a longtime member of the Equipment Leasing and Finance Association and an expert witness on leasing. His view was quite different: “I expect a recession within the next three or four years, not before. Interest rates will approach their normal level (5.5% for 30-year Treasuries), unemployment is already scary low (creates bottlenecks, higher wages) and confidence will ebb if any one of a number of events occurs — war, embargos, North Korea, Iran, take your pick. This is my gut feel, not based upon an econometric model.” Three to four years, not before. That seems to be quite optimistic — I’m sure President Trump would agree, wholeheartedly.
Anticipating a downturn at some point in the future, does the credit department let the thought of an impending recession influence the decision to approve or decline longer-term assets for mid-grade credits?
Andy Mesches, director at The Alta Group and former chief credit officer at Key Equipment Finance, provided his perspective: “Downturn is definitely a factor as well as industry, credit analysis and view of economy. My evaluation takes into consideration the following: Is it a current customer, where past performance is important; collateral value of equipment; expected industry performance based on past downturns and term of transactions. For [a] new customer, credit strength and collateral value take on additional importance.”
Mesches’ response is what you would expect from a traditional bank lessor. I suspect an asset-based lender might take a slightly different approach. Years ago, a chief credit officer I knew preached about the three legs of the stool: the customer and their credit quality, the asset and its collateral value and the deal structure. Reiterating what Snyder said earlier, lousy structures, longer terms and weak collateral combine for disaster. What some folks call “putting lipstick on a pig” is dressing up a C credit to make it look like a B.
Despite the surrounding pessimism, I urge readers to recognize we are presently experiencing a period of solid economic growth and the immediate outlook is very favorable. A May 17 Reuters report predicted “U.S. companies could plow more of the money saved from sweeping tax cuts into business investment later this year, perhaps even surpassing a jump in first-quarter capital expenditure that was the highest in almost seven years…With data in from 94% of S&P 500 companies, first-quarter capital expenditures total $159 billion, up more than 21% from a year ago and on track to be the highest year-over-year growth since the third quarter of 2011, according to S&P Dow Jones Indices data.”
These are the good times. Make hay while the sun shines, but don’t forget rainy days will come. You need to hope for the best, but prepare for the worst. Because we all know the next one is coming, we just don’t know when.
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