More data and insights.
Memo to: Vega Capital clients
From: Scott Shuttleworth
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Recall our model for understanding recessions...
A recession is defined as a contraction in GDP over at least two quarters. GDP production and production is the reflection of consumption. Consumption is comprised of spending via income or borrowings.
The level of spending is influenced by 3 main factors;
- The money supply
- Debt stress
If there is sufficient downside pressure on these elements, a recession can emerge.
Where are we now? (March 2019)
As it stands, we’ve seen the money supply contract through 2018 and into 2019. We haven’t yet seen debt stress and whilst we saw some negative signs of employment issues in early 2019, this latter factor has dissipated a tad.
Indeed, similar to Ray Dalio, earlier this year I believed that the chance of a recession was more than 50% through late 2019/2020. I now think Ray is right in bringing that back to about 35%. That said, it’s a volatile number, we could just as easily revert our stance back to over 50% next month so take this with a grain of salt.
But there’s more…
With that, let’s talk more about the state of the US economy. I recently watched Jefferey Gundlach’s interview on Real Vision (link here) who summarised the state of the US economy brilliantly - it had 5.3% nominal GDP growth (3% real) and debt increasing by 7% of GDP.
Thus the US economy is only growing due to more spending via debt (and much of this is debt is being created by the US Treasury).
Gundlach also noted that he saw no economic warning bells in September of 2018, but now they’re starting to show. This is similar to our stance at Vega Capital – we see the risk of a recession on the horizon but we haven’t yet gone short (and we won’t until we have a lot more supporting data).
The spooky thing is that economic growth is currently slowing (current forecasts are from about 3% real in 2018 to circa 2% in 2019). To keep up growth, more debt will be required.
But it’s harder to issue debt now than in the past. When rates were low, many subpar companies issued debt but could afford it due to low rates. Now that rates have risen/are rising, these companies will find raising more difficult.
Indeed, Morgan Stanley Research notes that if you were to use leverage ratios (i.e. how much debt to income or assets) as a market of creditworthiness, then 45% of the US bond market would be rated junk. Junk debt isn’t allowed in the mandates of many bond funds/ETFs and other mutual funds meaning they won’t be able to take on new issues/hold old issues.
These are complex issues for markets and investors to wade through. We’re intrigued to see how the economy deals with these challenges over 2019/2020.
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