WEEK OF DECEMBER 17, 2018 Weekly Relative Value The “R” Word: Recession “All of the ingredients are in place: a waning expansion that began in June 2009, almost a decade ago; heightened market volatility; the impact of growth-reducing protectionism; and the ominous flattening of the yield curve, which has predicted Tom Slefinger is recessions accurately over the past 50 years.” Senior Vice President, – Campbell Harvey, the founding director of the Duke CFO Global Business Outlook Survey. Director of Institutional Fixed Income Sales at Balance Sheet Solutions. Over the past 12 months, U.S. real GDP growth is expected to have grown by about 3.25%. If so, this will have been the best growth rate in the U.S. economy in a decade. Unfortunately, as we ring out the old and ring in the new, we may have seen the zenith in economic growth for this cycle. THIS WEEK… While growth has indeed rebounded, it is critical to understand that recent growth has not • $22 Trillion and Counting been driven by organic factors of rising wages and sustained underlying aggregate demand. • The “R” Word Instead, growth has been fueled by a confluence of natural disasters and a surge in deficit • Follow the Yield Curve spending. This creates the illusion of growth. However, the short-term stimulus from • Reversion to the Mean natural disasters combined with the fiscal boost will fade. Add in tighter financial • The Fed to the Rescue conditions, economic growth should be lower in 2019. • Rates Must Go Higher? • The Year of the Dog Fiscal Policy and Financial Conditions’ Impact on Real GDP • Happy Holidays! PORTFOLIO STRATEGY According to a Duke CFO Global Business Outlook Survey of more than 500 CFOs, including 226 from North American companies, 80% of corporate executives predict recession no later than 2020 and about half of those say it will happen as soon as next year. www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 2 In stark contrast to all the “animal spirits” of this time a year ago, a just released survey by NBC/Wall Street Journal (taken from December 9-12) showed just 28% of American households have a positive economic outlook heading into 2019, while 33% predict things will get worse. This is a downbeat assessment we have not seen in about six years. At the turn of the year, those numbers were sitting at 35% and 20%, respectively. The New York Fed’s recession model (based on the yield curve) rose from 14.1% in October to 15.8% in November — where it was in November 2008 (it was below 11% a year ago). Note that this metric doesn’t peak at 100% before the recession, but rather 30%-40%. So, on a “normalized” basis, it is basically saying that recession odds are between one- third and fifty-fifty odds. The St. Louis Fed’s recession model jumped last month to its highest level since the angst of March 2016. It is right where it was in September 2007, June 2000 (recession nine months hence), April1990 and December 1980. Overall these themes are consistent story of rising recession risks for 2019. $22 TRILLION AND COUNTING “I think it’s the three monkeys in Washington — I hear no evil, I speak no evil, I see no evil — about the reality of $1 trillion deficits that will frankly explode in the economic downturn.” – Mark Sanford, South Carolina Republican Representative On the fiscal side, U.S. national debt will likely hit the $22 trillion-mark next month. When Barack Obama entered the White House in January 2008, the U.S. was $10.6 trillion in debt, and so we have added $11.2 trillion of new debt to that total in less than 11 years. It doesn’t take a math genius to figure out that we have added an average of a trillion dollars plus a year to the national debt for more than a decade. But instead of getting our insatiable appetite for debt under control, Congress is actually accelerating our spending. When President Trump took office, he embraced tax cuts but rejected structural spending overhauls. According to the Committee for a Responsible Federal Budget, legislation passed in fiscal year 2018 accounts for almost half the $1 trillion projected budget deficit for 2019. www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 3 We have been spending far, far more money than we have been bringing in, and that has been propping up our economy. But we are progressively making our long-term problems much worse, and there is no way that we can sustain this Ponzi scheme for much longer. We have painted ourselves into a corner. The best-case scenario is that current deficits are really eating up domestic investment — which they are — and will continue to slow our economic growth. Worst-case scenario or scariest scenario, we’re heading for a debt-driven financial crisis. Out of Control Spending Moving on. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages and student debt. When the recession hits, the reduction in employment will further damage what remains of their consumption ability. Further, the downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby boomers now forced to draw on it. Yes, more government funding will be required to solve that problem as well. As debts and deficits swell in the coming years, the negative impact to economic growth will continue. “Corporate indebtedness is now quite high, and I think it’s a danger that if there’s something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector.” – Former Fed Chair Janet Yellen And let’s not forget Corporate America. Last week, Janet Yellen discussed the issue of leverage in the economy stating that companies are taking on too much debt and could be in trouble should some unexpected trouble hit the economy or markets. U.S. companies have re-leveraged their balance sheets, tempted by historically low borrowing costs. Indeed, U.S. corporate debt as a percentage of GDP is now at a record level, well above the previous peak in 2008. A bigger concern is the degraded credit profile of the corporate universe, which has been accelerating. To wit, the number of A to BBB downgrades doubled to a whopping $176 billion in the fourth quarter, just shy of the all-time high hit in the fourth quarter of 2015. With several weeks still left this quarter, it is likely that a new downgrade record will soon be hit. Currently, more than 50% of the investment grade debt carries a credit rating of BBB. If corporates were to be faced with the combined challenge of the increased cost of borrowing and potentially lower operating profits in an economic downturn, then it is likely that some would struggle. In other words, with rates rising, economic growth slowing (debt is www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 4 serviced from revenues), and the health of balance sheets deteriorating (BBB is one notch above “junk”), the risk of an “event-driven” credit crisis is real. Non-Financial Debt as % of GDP THE “R” WORD In the U.S., there are no imminent signs of a recession; however, as we head into 2019, quantitative tightening (QT) is expected to accelerate. QT, combined with expectations of further interest rate increases from the Fed, could drive the economy to a standstill next year. Europe is absolutely horrible in terms of economic growth. European auto sales fell in November for a third month in a row. France’s economics are in about the same state as its politics, with the Purchasing Managers’ Indices (PMI) data faltering to four-year lows. Ditto for Germany. For the entire continent, the Eurozone Composite PMI dropped to 51.3 in December from 52.7 (consensus was 52.8, so a big miss here). Italy’s industrial orders fell 0.3% in October to add insult to injury. This is consistent with the dovish tone emanating from the European Central Bank (ECB) meeting where President Mario Draghi did emphasize downside macro risks. Overall, it’s a relatively gloomy picture in Europe to end the year on. The eurozone economy has a relatively high reliance on trade and is at the mercy of the global trade cycle. Making matters worse, the ECB is out of sync with the U.S. Fed and could potentially face a global slowdown with negative interest rates and so little by way of monetary stimulus to offer. Global Growth is Slowing www.balancesheetsolutions.org BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 5 And China – whose recent economic data have been on the verge of disaster – is closely watched as the spark that could light the next global economic and financial conflagration. Note: it was China’s record credit burst in 2009 that dragged the world out of a global recession. Which brings us to the latest Chinese data, which showed that economic activity has further disappointed with industrial production missing and consumption/retail sales slowing. Of note, Chinese retail activity grew by just 8.1% in November. You have to go back 15 years to find something less. Troubles in China And unlike the 2008-2009 financial crisis, China simply has no monetary room with which to kick start any domestic growth. Therefore, the Chinese government is left between the rock and the hard place.