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Categories
Economic Indicators
Downturn in the U.S. financial cycle may be near
Jens Søndergaard
Currency Analyst

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.


U.S. financial cycle nears a peak

Line chart shows the U.S. financial cycle from 1971 through the second quarter of 2026. The cycle hit its previous peaks in 1988 and 2006, and its last trough in late 2013. The cycle is currently forecast to peak in the third quarter of 2022 and to decline from there.

Sources: Capital Group, Bank for International Settlements, Organisation for Economic Co-operation and Development, National Institute of Economic and Social Research. Actual data as of the third quarter of 2021; forecast through the second quarter of 2026. Index, 1971 = 0. Financial cycle data incorporates home prices and the stock of private-sector debt in the economy. Figures on the Y axis provide a scale to illustrate the magnitude of fluctuations in the financial cycle.

How financial cycles work


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.


Four phases of the financial cycle:
How equities and bonds have typically fared

Chart shows the four phases of a financial cycle, represented by a line passing from one phase to the next, from left to right. At phase 1 of the cycle, the line begins at a peak, but it moves lower as leverage in the economy declines at an accelerating rate. In phase 2, the cycle approaches a trough as leverage declines decelerate. Phase 3 begins at the trough, but the line moves higher as leverage increases at an accelerating rate. In phase 4, the line returns to a peak as leverage growth decelerates. The chart indicates that bonds tended to fare better in phase 1 and phase 4, while equities tended to fare better in phase 2 and phase 3.

Source: Capital Group. Data presented are for informational purposes only and are not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions, and actual results may vary significantly because future market characteristics may not match our assumptions. This illustration of financial cycles was developed using an economic model, historical data from 1974 to 2014, and the author’s judgment.

Is the U.S. financial cycle at risk?


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.


U.S. credit growth has slowed, house price gains may have peaked

Line chart shows the year-over-year percentage change in U.S. house prices and U.S. private-sector credit from 1970 to 2021. The two generally move in tandem, but they diverged sharply beginning in mid-2020, with house prices rising and private-sector credit declining. However, house prices had a modest decline in the fourth quarter of 2021, and private-sector credit had a small increase in the third quarter of 2021.

Sources: Organisation for Economic Co-operation and Development (house prices) and Bank for International Settlements (private credit). All data are adjusted for inflation based on consumption deflators. House prices as of the fourth quarter of 2021, and private sector credit as of the third quarter of 2021.

With inflation surging, credit growth could slow


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.


U.S. credit growth may lag surging inflation

Line chart displays U.S. private-sector credit from 1970 through the third quarter of 2021, and U.S. inflation from 1971 through the third quarter of 2021. It also includes a forecast of inflation through the third quarter of 2026. The chart shows that private-sector credit growth typically exceeds inflation, with a notable exception from 2009 through mid-2012, in the aftermath of the global financial crisis. In addition, inflation nearly exceeded private-sector credit in the third quarter of 2021. From there, inflation was forecast to continue rising to a peak around 7.5% in the second quarter of 2022, before declining to around 2% in 2024.

Sources: Capital Group, Organisation for Economic Co-operation and Development (inflation), Bank for International Settlements (private credit). Actual data as of third quarter 2021.
Note: Forecast is based on National Institute of Economic and Social Research February 2022 global forecast and Capital Group assumptions.

The U.S. is not the only financial cycle at risk


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.


Private credit growth slowing across developed markets

Line chart compares the year-over-year percentage change in private-sector credit in the U.S. with the median of 16 other developed market economies. The U.S. data begins in 1971 and the median data begins in 1972. Both run through the third quarter of 2021. The two largely moved in tandem, with more volatility in the U.S. data. The chart shows significant declines in both from the fourth quarter of 2020 on. Both were near zero growth as of the third quarter of 2021.

Sources: Bank for International Settlements, Organisation for Economic Co-operation and Development. As of third quarter 2021.
Note: Data are inflation adjusted based on consumption deflators.

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.


Many advanced economies are near a financial cycle peak

Table lists the financial cycle phase for various advanced economies and emerging markets as of September 30, 2021. Countries in phase 1 include advanced economy Sweden and emerging markets China, the Czech Republic, Malaysia and Mexico. Countries in phase 2 include advanced economies Finland, Ireland and New Zealand, and emerging markets India, Indonesia, Poland and Turkey. Countries in phase 3 include advanced economies Italy, Norway and Spain, and emerging markets Russia and South Africa. Countries in phase 4 include advanced economies Belgium, Canada, Denmark, France, Germany, Great Britain, Greece, Japan, the Netherlands, Portugal, Switzerland and the U.S., and emerging markets Brazil, Hungary, South Korea and Thailand.

Source: Capital Group. As of September 30, 2021.

The euro area financial cycle may be past its peak


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.


U.S. vs. euro area financial cycles

Line chart compares the U.S. and euro area financial cycles. U.S. data begins in 1971 and euro area data begins in 1972. Actual data runs through the third quarter of 2021, and both are forecast through the second quarter of 2026. The chart shows that the U.S. cycle is forecast to peak in the third quarter of 2022, and the euro area cycle peaked in the fourth quarter of 2021.

Sources: Capital Group, Bank for International Settlements, Organisation for Economic Co-operation and Development, National Institute of Economic and Social Research. Actual data as of third quarter 2021; forecast through second quarter 2026. Index, 1971 = 0. Forecast based on the most recent global forecast from the National Institute of Economic and Social Research. Financial cycle data incorporates home prices and the stock of private-sector debt in the economy. Figures on the Y axis provide a scale to illustrate the magnitude of fluctuations in the financial cycle.

China financial cycle is past its peak


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.


China financial cycle is past its peak

Line chart shows China’s financial cycle from 1988 to the third quarter of 2021. It shows that the cycle peaked in mid-2019 after rising steadily from its last trough around mid-2008. The cycle is forecast to continue declining through the second quarter of 2026.

Sources: Capital Group, Bank for International Settlements, Organisation for Economic Co-operation and Development, International Monetary Fund, National Institute of Economic and Social Research. Actual data as of third quarter 2021; forecast through second quarter 2026. Forecast based on the most recent global forecast from the National Institute of Economic and Social Research. Financial cycle data incorporates home prices and the stock of private-sector debt in the economy. Figures on the Y axis provide a scale to illustrate the magnitude of fluctuations in the financial cycle.

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.


Conclusion


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.



Jens Søndergaard is a currency analyst with 16 years of industry experience (as of 12/31/21). He holds a PhD in economics and a master’s degree in foreign service from Georgetown University.


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