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Debate: What Will Trigger the Next Recession?

(Bloomberg Opinion) -- The U.S. economy has been growing since the last recession ended in June 2009, making this expansion the second-longest in the postwar era. But something inevitably brings all growth cycles to an end, causing the economy to stumble into recession. Bloomberg Opinion columnists Conor Sen and Noah Smith recently met on line to discuss the potential sources of the next slump.  

Conor Sen: As trade-war fears escalate once again, sending jitters through markets, it’s a good time to evaluate the state of the U.S. economy and how likely recession is over the next say 12 months. At a high level we should be skeptical of recession being imminently on the horizon for two reasons.

First is the Federal Reserve. If you have to point to one consistent cause of recessions over the past several decades, it’s the Fed overtightening, eventually leading to an investment or credit contraction. While the Fed has been increasing interest rates at a pace of about 0.25 percent per quarter, interest rates aren’t yet at neutral — though they’ll probably get there in the first half of next year — and the yield curve is not yet inverted, meaning that longer-term interest rates are still above shorter-term interest rates. Historically, an inverted yield curve tends to be a decent signal of recession over the intermediate term. A quick and dirty Fed/yield-curve model would argue that the earliest we should anticipate recession would be 2020.

The second factor is housing, which continues to grow at a slow and steady pace. We know that housing costs are high and we have a shortage of housing. The homeownership rate is just now beginning to increase from multidecade lows. Millennials have the peak of their homebuying years ahead of them. Lennar, one of the nation’s largest homebuilders, reported earnings this week and said that higher interest rates and commodity costs aren’t yet affecting demand. Demographically, we should have years of housing growth ahead of us, almost regardless of what the economy does.

Noah Smith: I also think the yield curve points to a recession in about 2020, at least if the current flattening trend continues. Another leading indicator pointing in the same direction is credit spreads. These have been very low lately, meaning that credit conditions have been pretty lax.

That usually tends to signal a future tightening of credit and thus, often, a downturn about 1.5 to two years later. In other words, I think the Minsky hypothesis that lending gets too easy at the peak of a cycle and precipitates a bust — may have something to it. Combine that with Fed tightening, and with the fact that recessions have happened at lower and lower interest rates in recent years, and you could have all the ingredients for a credit-driven bust in 2020 or so.

But that does leave the question of where the overborrowing would come from. If millennial demand pushes up housing prices and thus lets mortgage borrowers keep refinancing, as they did before 2007, it could avert any wave of mortgage defaults at least for a while. What about corporates, or consumer debt like credit cards and student loans?

CS: I think weakness in the corporate credit sector would come about from growing bottlenecks in the economy. Consumption weakness is the biggest risk I’m worried about. We know about the low unemployment rate, which is making it harder for companies to find workers, particularly low-wage service workers. A truck-driver shortage is putting upward pressure on freight rates, which will eventually get passed along to almost everything we buy. UPS appears to have a labor deal with its union that will see part-time drivers get raises to $13 from $10 an hour beginning in August.

A trade war would compound these issues. Raising the price of raw materials like steel, aluminum and lumber would serve to both squeeze corporate profit margins and make goods for consumers more expensive.

With consumers facing higher prices, they’re able to buy less stuff, hurting corporate revenues. Corporations that borrowed too much this cycle will find themselves getting squeezed both on the cost side and the revenue side, and carrying all that excess debt leaves them little room to maneuver. And there’s your credit bust. What do you think?

NS: The idea of a crash in corporate debt is an interesting one. Nonfinancial corporate debt is now at about 31 percent of gross domestic product, which is an all-time high.

We’ve all heard the stories of private-equity firms buying companies and levering them to the hilt; maybe that’s just part of a larger trend.

So the recession scenario goes like this: A stock bust induced by a combination of trade war and rate hikes, along with the natural Minsky-type expansion of risky debt at the top of the cycle followed by a wave of corporate defaults, with the usual mix of wealth effects and consumer retrenchment exacerbating the problem.

That sounds all too plausible. A corporate-debt-triggered recession seems more likely than the scenarios people typically envision another housing bust or tech-bubble bursting if only because people aren’t paying attention to it. The non-financial, non-tech corporate sector has sort of sailed along under everyone’s radar, meaning problems may have been allowed to build up unobserved. And because debt crashes tend to cause worse recessions than stock crashes, this kind of recession could be more painful than the relatively mild downturn of 2001.

Two questions. First, do you have any idea what corporate sectors might be particularly vulnerable, and hence be good places to watch? Second, how much do you think President Donald Trump’s trade war could really hurt U.S. corporates?

CS: The biggest risks I see are to labor-intensive, low-profit-margin consumption businesses, particularly ones that cater to young urbanites. My view is that the labor tightness we’re seeing is structural, particularly for low-wage service jobs. The days of being able to pay people less than $10 an hour to do anything are coming to an end. Having thin profit margins gives you less of a cushion to handle rising costs and makes that debt more of a burden. And then as millennials age into their family-forming years, budgets are going to shift to housing and day care away from eating and drinking out. Restaurant franchises seem particularly at risk.

As for the trade war, and anything Trump-related, it’s nearly impossible to predict. Maybe we’ll get a little clarity as companies start reporting their second-quarter earnings in a few weeks, but even the Fed has said it has very little insight into how a trade war could affect the economy. There are just too many unknowns.

One last comment on the risks to corporate credit another factor beyond economic trends that could have an impact on labor costs, commodity costs and profit margins is just the rise in interest rates. A lot of debt was issued during the last several years when interest rates were low to finance stock buybacks. For companies that carry a lot of debt, merely re-issuing debt as it comes due at an interest rate two or three percentage points higher than it was when issued several years ago will be enough to cause problems.

NS: This scenario makes sense, but I’d like to offer a word of caution. Corporate debt is high relative to economic activity, but earnings are also high companies are managing to squeeze out more profit, possibly as a result of increased market power. So it could be that companies are rationally borrowing more, because monopoly power is allowing them to support a higher debt burden. That doesn’t preclude a monetary-policy-induced recession, but it could mean that there’s less bad debt in the system than the numbers suggest.

In any case, I think we’ve identified a worrying scenario for a recession in the next couple of years, but macroeconomic forecasts are notoriously hard to make, so I think we have to regard this as just one possibility to look out for.

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