With the U.S. Federal Reserve in a full-on fight against inflation, concerns are rising that tighter monetary policy could tip the U.S. economy into a recession. A look at longer-term financial cycles underscores the risk.
I have studied financial cycles in the United States and around the world to gain a vantage point on the global economy and asset values that differs from the view that standard business cycles provide. Since I update my models on a periodic basis, my investment colleagues and some of our clients have asked what I think about the current U.S. financial cycle.
My view is that it will peak later this year, much sooner than the late 2023 or early 2024 peak that I expected a year ago. A turn in the U.S. financial cycle would be bad news for U.S. economic growth in the medium term. Further, financial cycle peaks often precede periods of financial distress. This could spell trouble for highly leveraged areas of the U.S. financial system, such as the riskiest corners of the high-yield (BB/Ba and below) bond market.
As a reminder, financial cycles are derived from trends in house prices and the amount of private-sector debt in an economy. Economists use house prices to gauge perceptions of value and risk, and the stock of private-sector debt as a harbinger of rising leverage in the financial system. The interplay between these factors can ultimately translate into economic booms and busts, and episodes of financial distress. For example, the last peak in the U.S. financial cycle in 2006 — driven by soaring house prices and a surge of consumer debt — preceded the global financial crisis.
Financial cycles usually last much longer than business cycles, which track economic expansions and recessions. A good analogy is to think of financial cycles as seasons and business cycles as changing weather patterns.
There are four distinct phases of the financial cycle, corresponding to the trend of leverage in an economy. Turning points in financial cycles often coincide with changing fortunes for equity and bond markets. My analysis of more than 40 years of asset class returns shows that bonds tended to fare better than equities around financial cycle peaks, while equity returns were typically stronger around financial cycle troughs.
The U.S. financial cycle is nearing a peak. This incorporates the global effects of the Russia-Ukraine conflict, including much higher commodity prices, a slowdown in global trade and greater uncertainty for households and businesses. Plus, a more hawkish Fed is spurring higher U.S. interest rates, which is driving up home mortgage costs. These headwinds are hitting the U.S. economy when there were already tentative signs of slower growth in U.S. private-sector credit and house prices.
At this point, the U.S. financial cycle is effectively dependent on U.S. house prices continuing to grow strongly, which would support further credit growth. But it is hard to see double-digit house price increases continuing for long. Inflation-adjusted home prices are already well above trend and mortgage rates continue to rise, with the average 30-year fixed-rate mortgage recently exceeding 5% for the first time in more than a decade.
The surge of U.S. consumer price inflation to 40-year highs is a key factor weighing on the U.S. financial cycle. Financial cycles track house prices and credit growth in inflation-adjusted terms. So, the cycle can only accelerate if these factors are rising faster than inflation.
Nominal private-sector credit growth in the U.S. has usually exceeded inflation since 1970. But now inflation has surged, and nominal private credit has slowed. It is hard to see a catalyst for a pickup in credit growth when the Fed is aggressively raising interest rates. Absent a substantial private-sector re-leveraging, credit growth is likely to slow further and turn negative in real terms during 2022. This has happened before — namely during the last two peaks in the U.S. financial cycle in the late 1980s and 2006–2007.
This is not just a U.S. issue. There have also been signs of a sharp downturn in the credit cycle in other developed markets. Median credit growth was nearly flat for a basket of 16 developed markets as of the third quarter of 2021. To be sure, this was distorted by the big credit surge in 2020. Still, the current underlying credit trend is a lot more muted than it was prior to the outbreak of COVID-19 and even more so than before the global financial crisis.
Given the global nature of the recent inflation surge and a withdrawal of liquidity by major central banks, we could very well see most financial cycles pushed closer to peaks or further into deleveraging. This would be negative for equities. If this inflation persists into 2023 and credit cycles stay muted, we are likely to see most countries pass their financial cycle peaks.
While this could lead to financial distress, I see less risk of it ending in a global credit crunch because global banks have much stronger capital levels than they had prior to the financial crisis. But it is hard to argue with the fact that most developed countries are now firmly in the late stages of the financial cycle.
The latest data suggests we are already past the peak in the euro area financial cycle. Outside Germany, there are no signs of a euro area credit or housing boom. The current surge in euro area headline inflation will only make it harder for a real acceleration of private-sector credit to take hold.
Germany’s housing market has been quite strong, but its credit growth has begun to decline. The euro area periphery saw credit growth in 2020 after a decade of deleveraging following the financial crisis, but that is starting to slow and may have just been a temporary effect of the pandemic.
I think this is bearish for the euro in relation to the dollar. Not only is the euro area financial cycle weakening faster than the U.S. cycle, but the Fed is on a more aggressive path of monetary policy tightening than the European Central Bank. This will make the real rate differential more favorable for the dollar. Europe is also much more vulnerable to disruptions of energy supplies from Russia.
China’s financial cycle surged for years after the global financial crisis as Chinese households and companies took on massive amounts of debt. The cycle got a further boost from government stimulus in 2020 in response to the pandemic.
But now China’s financial cycle has passed its peak. The authorities have struggled to manage an orderly deleveraging process. House prices and home sales are falling, and many property developers are under significant credit stress. A series of lockdowns under China’s zero-COVID policy could continue for the rest of this year and even beyond. This would likely weigh on already weak consumption, further depress home sales and exacerbate rising unemployment.
All of this is likely to produce a significant slowdown in China and further supply chain disruptions that may drag down global growth. This is likely to have negative repercussions for export-dependent emerging markets that rely on Chinese demand, including Vietnam, Malaysia and Brazil.
Compared with a year ago, many countries have moved closer to or even beyond financial cycle peaks. Rising inflation, higher interest rates, a slowdown in China and the Russia-Ukraine conflict are all feeding the trend. House price gains since the onset of the COVID-19 pandemic are looking increasingly vulnerable in many countries, and growth of private-sector credit has flattened across advanced economies. While a financial cycle peak does not necessarily signal that recession is imminent, it does suggest that a period of deleveraging lies ahead, potentially weighing on global economic growth.
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