The Next Recession is Coming – Here’s How to Prepare
Commercial Credit, Enterprise Risk Management, Recession Ready
As recent stock market fluctuations are telling us, a recession is coming – and the market knows it. What kind it will be and how soon it will happen is still unclear. While we can’t predict the future, current economic conditions can help us understand the type of recession we may face, giving insight into the changing business cycle and how to prepare for what’s to come.
Understanding Business Cycle Expansions and Contractions
The U.S. business cycle recently passed a major milestone by achieving the longest continuous expansion. This expansion cycle has now set a new record for length at over 10 years, reached in June 2019. While this gives confidence to investors, business leaders and consumers, record expansion also gives pause. Can economic growth continue? Or, will the economy revert to a more normal phase of periodic expansions and contraction cycles over a period shorter than 7 years?
Imbalances can develop easily in a massive economy such as that of the U.S. Geo-political risks, trade issues and a presidential election are a few of the many external factors that could tip the scales.
Business leaders are rightly asking for guidance on the kind of instabilities that could develop; the likely scenarios that could result; and ways to prepare their firms to adapt to a changing business cycle.
Recessions – or business cycle contractions – generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock or the bursting of an economic bubble. In the U.S., it is defined as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. The U.S. has encountered 32 cycles of expansions and contractions, with an average of 17 months of contraction and 38 months of expansion since 1850. Recessions are becoming less frequent, as only four have been recorded since 1980:
- July 1981 – November 1982: 15 months
- July 1990 – March 1991: 8 months
- March 2001 – November 2001: 8 months
- December 2007 – June 2009: 18 months
Recessions fall into four types:
- The Dot-Com bubble and subsequent crash was a boom/bust recession. During the boom the economy grows, jobs are plentiful, and the market brings high returns to investors. In the subsequent bust, the economy shrinks, people lose their jobs and investors lose money.
- In a balance sheet recession – such as The Great Recession of 2009 – financial institutions see a large decline in their balance sheets due to falling asset prices and bad loans. Because of large losses, they need to restrict credit and lending, leading to a decrease in investment spending and economic growth. This is accompanied by declining asset prices. For example, a decrease in home prices causes a decline in consumer wealth, resulting in increased bank losses. Thus, growth slows. During the 2008-09 recession, bank losses led to a sharp decline in bank liquidity, with banks finding themselves short of cash. This caused decreased bank lending, making it difficult to secure funds for investment. Combined with a collapse in consumer confidence, the economy went into recession – despite interest rates being cut to zero. Balance sheet recessions generally last a long time. Cutting interest rates generally provides little relief, and double-dip recessions become common.
- A demand side shock recession is caused by a decrease in consumer confidence, such as what happened after the 9/11 terrorist attacks.
- A supply side shock is an event that suddenly increases or decreases the supply of a commodity or service, or of commodities and services in general. This sudden change affects the equilibrium price of the good or service or the economy's general price level. For example, a steep rise in oil or gas prices or a natural disaster causing a sharp fall in production could cause an adverse supply side shock. In 1973, a very rapid rise in oil prices caused a recession due to the decline in living standards. At that time the world was highly dependent on oil, so the tripling in the price of a barrel of oil caused a sharp fall in disposable income and also caused lost output due to lack of oil.
The Next Likely Recession
The economy has recovered from the Great Recession through the longest and slowest economic expansion the U.S. has seen, but its scars remain. Its impacts have been felt in the labor market, income bands, housing and wealth, along with credit scores and access to credit. Businesses and consumers want to know when the next recession will take place, what kind it will be, and what impact it will have on businesses and portfolios.
While economic downturns and recessions are difficult to predict, many leading indicators are showing that the U.S. will be slowing down from our expansionary stage. We should be prepared for a recession within the next two to three years. So, what’s next?
The world is less dependent on oil than it was in the 1970s, and the U.S.’s role as the leading producer of oil reduces the likelihood of a supply side-induced recession from oil shortages. However, other critical economic inputs could induce a supply side shock recession. For example, rapid policy changes in the use of data or in the production and distribution of energy could cause disruptions in supply of these key resources. The consensus is that a supply side shock recession is a lower probability and other forms of recession are more likely.
A demand side shock is more plausible. For example, a geopolitical event such as a war breaking out in the Mideast or Asia could easily derail consumer confidence. Another potential is a political scandal causing an abrupt change in governing institutions. If foreign sources of capital to fund debts suddenly dry up, that could raise interest rates, abruptly impacting consumers’ access to and cost of debt.
The case also can be made that several asset bubbles exist today. Credit markets operate at unusual levels with negative interest rates in some well-developed countries. Boom/bust scenarios abound in the form of high cost technology companies with PE ratios in excess of historical norms. Some argue that student loans, credit card balances and car loans are bubbles primed to pop. Another possibility could be the corporate debt level, with high “speculative debt” and leveraged buyouts by private equity firms. When a slowdown takes place, it could see many defaults and bankruptcies, especially in what is dubbed the retail apocalypse.
Trade wars and tariffs add another level of uncertainty. As businesses are starting to feel tariff pressures on production, they will be passed to the consumer in the form of higher prices. And, with the devaluing of the Chinese Yuan, China’s products are cheaper for importing even with the tariffs, which ultimately could limit U.S. exports. Price increases and trade uncertainty might lead to contractionary spending, resulting in an economic downturn, decreased production and increased unemployment.
Prepare, Prepare, Prepare
PayNet has calculated the impact of the next recession on commercial credit portfolios by measuring defaults, exposures at default, and loss given default. The expected loss results for a moderate recession show that most commercial credit portfolios will experience loss rates that are materially higher than current loss rates. While the expected next recession will probably be moderate and much less severe than the Great Recession, default rates are expected to rise to long-term averages. Loss rates given defaults also are expected to jump higher, accelerating higher expected loss rates. In the case of a moderate recession, the combined impact of rising defaults and increased loss rates will be magnified by increased losses on collateral.
A first step for commercial lenders would be to run their portfolios through a moderate recession scenario. PayNet’s Stress Test Simulator provides insight into an organization’s strength and resilience to weather unfavorable economic environments – from a progressive slowdown to a worst case scenario similar to the Great Recession. We also recommend lenders run custom scenarios that take into consideration the uniqueness of their geographies and industries. PayNet is here to help and offering recession scenario results upon request.
Learn more and get prepared.