«There's a lot at stake in this global recession, not just from an economic and financial standpoint but also from a political and social one.»
In his daily publication «Breakfast with Dave», David Rosenberg has been warning for quite some time about the high corporate debt level. He has warned that in an economic downturn this debt bubble will burst. With the Sars-CoV-2 pandemic the global recession is now a fact. According to Mr. Rosenberg, the corporate debt level will dampen the economic recovery in the second half of the year. Market participants are still underestimating the risk of a prolonged downturn.
Mr. Rosenberg, what does the outbreak of the Coronavirus mean for the economy?
There have been four pandemics prior to the Coronavirus. All in the past century. Each one ultimately generated a global recession. This time isn’t different.
What will this recession look like?
It’s causing an unprecedented withdrawal in economic activity. That’s in and of itself a big problem, especially if it’s a highly over-levered economy, and where so many households are living paycheck-to-paycheck. On top of that, the hit on the small business sector is huge, and that’s two-thirds of the economy. There’s a lot at stake in this global recession, not just from an economic and financial standpoint but also from a political and social one.
How deep will the fall in activity be?
The initial shock to the economy will be very severe. Real GDP in the second quarter will likely contract at the highest rate ever, and we had only two quarters in the post-World War II period where US GDP fell at more than 8% annual rate. But it’s unclear how deep this shock will be, and that’s what the markets are grappling with.
What happens after that?
I don’t expect a V-shaped recovery. We will probably have a flat or a negative third quarter and will start to recover before the end of the year.
Is there any crisis in the past that is comparable to this one?
This crisis is unprecedented. Because we have five shocks occurring at the same time: A global demand shock, a global supply shock, a negative wealth shock, an oil shock, and a credit shock. We have never stress-tested the global economy and especially the US economy with a recession at such a gargantuan level of corporate debt on business balance sheets. And most of that debt was used to buy back stocks and not to engage in productivity-enhancing capital expenditure.
What will happen?
The risk is that debt to equity ratios in the business sector are going to skyrocket and create a negative feedback loop in the economy, with downgrades, delinquencies, and defaults. And this is where people get it wrong.
What do they get wrong?
People think that bubbles cause recessions. But it is the other way around. It is the recession that causes the bubble to burst. This recession is going to expose these over-leveraged balance sheets in the corporate sector and lead to a second wave down in economic activity. That’s why there is no chance of V-shape recovery.
When will this second wave hit?
The credit shock will take over in the second half of the year. It doesn’t mean we have an elongated recession. It means that there’s going to be plenty of factors related to balance sheets, and they’re going to frustrate the extent of any recovery.
Is this the only bubble that will burst?
There will be all sorts of knock-on effects. We also have bubbles in ETFs, in high yield, in leveraged credit and in housing markets in most parts of the world, including Canada and Australia. But the big bubble is corporate balance sheets globally, not just in the US. It was the most acute debt for equity swap of all time. We’ve never gone through such a cycle of debt-financed share buybacks to create the illusion of robust corporate earnings.
Will this lead to a banking crisis?
I doubt it’s going to lead to a 2008/2009-style banking crisis. Banks are much better capitalized. Not every single bubble bursting experience has to include the banks. This is about debt outside of the traditional banking sector, and the owners of this debt are much more diverse. It’s mutual funds, hedge funds, sovereign wealth funds, and pension funds.
Any other risks for banks?
There are $2,4 trillion of commercial and industrial loans sitting on bank balance sheets. They’ve doubled in this cycle. They have even overtaken consumer and mortgage loans on bank balance sheets. The quality of these borrowers is questionable because anybody with a credit rating went to the public debt markets.
So there is trouble ahead for banks.
Banks will be forced to raise their loan loss provisioning. That impact, along with 0% interest rates and what will turn out to be a very flat yield curve pressing against the zero bound is going to impair banking sector profit margins on a semi-permanent basis. I don’t see capital problems for US banks, but their return on equity will decline for a sustained period.
Is the Federal Reserve out of ammo?
The Fed is throwing spaghetti against the wall to see what sticks. The Fed is well equipped to provide liquidity to the marketplace. But their impact on the economy is no better than cushioning the blow. It’s not a monetary policy shock that caused the recession. Interest rates were already extremely low.
What else can the Fed do?
Monetary policy is not the right antidote. The Fed is out of traditional bullets. The only thing that would be beneficial is if Congress gives the Fed the power to buy corporate bonds or equities, which the ECB and the BoJ have already been doing.
Will this happen?
We know how aggressive the Fed has already been, and we know that if Congress does allow them to expand their balance sheet with other assets, the Fed will do that. It looks as if the economy and the stock market were joined at the hip. So if it takes the Fed to put a floor under the stock market they’ll do everything they can.
Why does the Fed want to put a floor under the stock market?
When the stock market goes up and up and up, everybody thinks they’re a genius, and this is how markets operate. But when it goes down we need the government to come in to support it. The Fed is a big believer in the wealth effect. When its former President Ben Bernanke embarked on QE2 a decade ago, he made it very clear that this was aimed at eliciting a wealth effect on spending.
Does this still hold today?
That narrative permeates the Fed. We either end up with the Fed coming in and buying risky assets, or we’ll get debt monetization. In fact, we’re heading towards that strategy in any event.
What about negative interest rates?
I’m not expecting that. There’s a lot of reluctance from the Fed to go negative. Expanding powers to load the gun on QE is going to happen before we see negative interest rates. Negative rates impair the banking system. And there’s no evidence that this did any good in Europe or Japan.
Is monetary policy working?
No. The problem goes beyond the scope of what the Fed has already done. And the Fed did as much in a couple of weeks as it did in 2008/2009 together. Even safe-haven assets aren’t safe anymore. Margin calls lead to forced selling in Gold, Municipal Bonds, and Treasuries. We are still having major pockets of liquidity problems, even after everything the Fed has done. There’s still tremendous dislocation, and I’m not talking so much about the action in risky assets. They are cyclical and will respond to accelerating recession concerns. But the action in the treasury market has got to be concerning.
Why is that?
The Fed has eased policy dramatically, but we’ve seen real rates go up, and inflationary expectations have fallen through the floor. Inflationary expectations are about the lowest level since 2009. That is not constructive from a Fed policy standpoint. It’s not that monetary policy has failed, perhaps the problem is even bigger than the aggressive policy response that we’ve seen.
What can be done to ease this problem?
It’s a matter of generating confidence. And that is not just sending out thousand dollar checks to the household sector. We need something much bigger. We need policymakers to show that they understand that this recession is going to create a major credit dislocation, that we’re on the precipice of a huge default cycle.
How do you rate the fiscal response?
It has been inadequate. Part of that is the political process in the United States. We have to wait for all the horse-trading between the White House and the House of Representatives. The Treasury Secretary Steve Mnuchin said that without the policy response employment rate will go to 20%. The last time that the unemployment rate in the US got to 20%, which was in 1932, GDP contracted roughly 15%. A fiscal stimulus of $2 trillion is a very tepid response.
Do you see a prolonged time of deflation ahead?
I do. We went into this situation with global inflation peaking at its lowest level in the post-World War II period. We had no cushion on inflation. Nor did we have a cushion on interest rates or economic growth. Although people like to say that the US economy was on a solid footing, we already know that global economic activity had weakened to its most sluggish pace since 2009. This is a major deflationary shock, both structural and cyclical.
Where will markets go from here?
We’ve seen a lot of damage already. The PE-ratio of the Dow Jones Industrial peaked at 23 and came down to 18, a huge move in a short period. The long-run average is 20, and a non-recessionary correction trough it’s 15, but if we’re talking about a true recessionary bear market trough, it’s more like 13.
It will get worse before it gets better?
I don’t think that we hit bottom on multiples. And we are in a complete bog when it comes to the earnings outlook. A plain vanilla recession would take the S&P 500 down to 2250. It looks like we’re getting there quickly. The first one-third of this move in the stock market was removing the froth from last year’s fourth quarter, the next third was pricing in the prospect of a recession, and then the third was pricing in the reality of a recession.
But it doesn’t sound like a plain vanilla recession.
If this is the sort of recession that Steve Mnuchin alluded to, it has probably a lot more downside. And when we hit the low there will be a period of testing and retesting. When we have testing and retesting that are successful it’ll be time to get back in. But you don’t have to be a hero and do it all at once. The bigger pain trade is to be early rather than late.