On The Margin

The Recession Paradox | Alfonso Peccatiello

Wed Jul 19 2023

US economyrecessionary forcestightening policycredit conditionsbank reservesmoney printingcredit creationstructural growthstock market performancebond performancemonetary policy

Description

The episode covers various aspects of the US economy, recessionary forces, tightening policy, credit conditions, bank reserves, money printing, credit creation, structural growth, stock market performance, bond performance, and the outlook for monetary policy. Key insights include the role of credit in transmitting monetary tightening, the impact of fiscal transfers on the private sector, the relationship between bank reserves and stock market returns, and the potential for bonds to outperform equities in the next six months. Overall, the episode provides a comprehensive analysis of the current economic landscape.

Insights

Credit plays a significant role in transmitting monetary tightening

The credit channel is crucial in transmitting monetary tightening to the real economy. However, the current cycle has seen a massive credit bonanza, allowing households and corporates to lock in long-term financing at low rates, reducing immediate refinancing needs. As long as corporates are not forced to refinance and have lengthened their liabilities' duration, lags can take longer before recessionary forces prevail.

Access to credit has been important for compensating low structural growth rates

Many economies with low structural growth rates have relied on access to credit to generate stronger cyclical growth. The private sector balance sheet has been used to access credit, allowing for increased economic activity despite low structural growth. Total credit to the economy as a percentage of GDP has grown over the last 30 years, highlighting the importance of credit in supporting economic growth.

Bank reserves do not strongly correlate with stock market returns

Changes in bank reserves explain only about 3% of S&P 500 returns. Banks primarily buy Treasuries, corporate bonds, and mortgage-backed securities with their reserves, rather than stocks. While portfolio rebalancing can have a marginal effect on stock prices, it is not strong enough to cause significant declines. Other factors, such as interest rates and inflation trends, play a more significant role in stock market performance.

Bonds may outperform equities in the next six months

On a volatility-adjusted basis, bonds may have a window to outperform equities in the next six months. As the market anticipates an economic recession and uncertainty remains about the timing of monetary policy tightening, bonds could provide better volatility-adjusted returns. Investors should consider including bonds in their portfolios to protect against credit events or recessions.

Chapters

US Economy and Recessionary Forces
Tightening Policy and Credit Conditions
Credit Impulse and Monetary Policy
Bank Reserves and Credit Creation
Money Printing and Bank Reserves
Fiscal Deficits and Money Printing
Bank Funding and Credit Creation
Structural Growth and Credit Access
Stock Market Performance and Bank Reserves
Bond Performance and Economic Outlook
Monetary Policy and Market Performance

Summary

Transcript

US Economy and Recessionary Forces

00:00 - 07:29

The first six months of 2023 have not seen a recessionary force prevail in the US economy.
The NBER's seven sub indicators for recession are annualizing at about 1% growth, which is below trend but not consistent with a recession.
Monetary lags are playing out in line with historical standards, with the inversion between the two-year and ten-year yield curve taking between 13 and 21 months to play into recessionary forces.
Inflation was high during the Federal Reserve's hiking period, causing a considerable slowdown in the economy. However, since October, as inflation has gone down, there has been a reversal and a mid-cycle slowdown.
The credit channel plays a significant role in transmitting monetary tightening to the real economy. However, this cycle saw a massive credit bonanza that allowed households and corporates to lock in long-term financing at low rates, reducing immediate refinancing needs.
As long as corporates are not forced to refinance and have lengthened their liabilities' duration, lags can take longer before recessionary forces prevail.
The current period of Ilkhov inversion is becoming more dangerous after month thirteen.

Tightening Policy and Credit Conditions

07:09 - 14:20

The Fed is trying to keep policy tight despite economic growth slowing down.
Keeping rates tighter for longer exerts a net tightening pressure on the economy.
Investors should consider the length of financing for corporates and mortgages.
Refinancing cliffs should be avoided by scattering funding over time.
Tighter financing conditions will gradually force private sector agents to accept them.
Over time, tighter conditions will affect a broader proportion of the private sector.
Bank credit in the US is not the only thing to look at; other forms of credit exist.
The credit impulse index shows that credit generation for the private sector has slowed down in the US, UK, and Europe.
Mortgage generation and access to cheap credit have both decreased for households and corporates.

Credit Impulse and Monetary Policy

13:58 - 21:05

Access to cheap credit for corporates is tougher before the pandemic, resulting in lower appetite for borrowing from the private sector.
Confusing stock market euphoria with monetary policy logs and how the economy works can be a potential mistake.
The price of credit objectively and unarguably is much higher now.
Availability of credit is still relatively good in the US, with only around 3% of companies reporting financing as an issue.
Late cycle bank lending tends to look robust due to high loan yields and positive late cycle fundamentals.
Credit impulse started declining aggressively in 2022 and reached low levels by Q1 2023, but has stabilized since then at those low levels.
Fiscal transfers injected money into the private sector in 2020, boosting spendable money for households and corporates.
Massive increase in credit impulse at the end of 2020 led to a subsequent increase in earnings per share in 2021.
Credit impulse has been dropping since late 2021/early 2022 due to the end of the credit bonanza of that period.

Bank Reserves and Credit Creation

20:45 - 27:58

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Central banks print bank reserves, not money for the private sector
Quantitative easing and portfolio rebalancing effect explained
Bank reserves accumulate while bonds are taken away from financial institutions
Pension funds and banks have more idle financial bank deposits
Low volatility and excess bank reserves can lead to companies being more aggressive in credit creation
Buying corporate bonds does not increase the money in the system, it's the action of levering up by corporations that increases credit

Money Printing and Bank Reserves

27:35 - 34:53

Credit creation occurs when individuals take on mortgages and corporations leverage up.
Banks can buy bonds using reserves or through the repo market.
Bank reserves in Japan increased significantly in the 90s, but real economy money circulation shrank.
Real economy money creation happens when the private sector decides to lever up and access credit.
Bank reserves can be used to rebalance portfolios, but if corporates don't issue new bonds, it becomes a hot potato situation.
Real economy money printing only happens under three conditions: fiscal deficits not offset by an increase in the treasury general account, cutting taxes without asking for anything back, and increasing disposable income without taxing it.
Europe's underperformance in GDP and inflation from 2012 to 2020 can be attributed to austerity programs.

Fiscal Deficits and Money Printing

34:26 - 41:57

Fiscal deficits and money printing increase bank accounts and net worth of individuals like Jax.
Bank accounts become liabilities of the banking system.
Government transfers reserves from the Treasury General Account to private banks to pay for increased bank deposits.
Government issues bonds as an offsetting item on the liability side to fund fiscal deficits.
Primary dealers use reserves to buy government bonds.
Fiscal deficits increase bank deposits, which in turn increase bank reserves used to purchase bonds.
Quantitative easing allows banks to acquire bonds without using existing reserves.
Real economy money printing occurs through fiscal deficits, not quantitative easing.
The second way to print money is through bank lending, where banks credit accounts and create new loans as assets.
Bank deposits from house sales return to the banking system as liabilities.

Bank Funding and Credit Creation

41:31 - 48:41

Banks create credit and assets, and they need to find new funding sources.
The interbank lending market is now dead, and the secured repo market is the main source of funding for banks.
Banks can attract funding by posting collateral such as treasuries.
Credit creation by banks does not rely on existing deposits or reserves in the system.
Bank lending is considered real economy money printing at a system level.
Single banks may need to find funding for every new loan and asset they create if they cannot retain or attract new deposits.
The Federal Reserve provides facilities for banks to access funding, but it can be expensive compared to traditional deposits.
There are also non-bank sources of credit creation, such as capital markets and shadow banking.
Structural growth has been low in many economies due to demographic factors and limited productivity gains.
Access to credit has been important to compensate for low structural growth rates.

Structural Growth and Credit Access

48:17 - 55:37

Structural growth rates in some economies are below 1%, which is not socially acceptable.
Access to credit has allowed the private sector to generate stronger cyclical growth.
Many virtuous economies have low levels of government leverage and use the private sector balance sheet to access credit.
Total credit to the economy as a percentage of GDP has grown over the last 30 years.
Quantitative tightening by the Federal Reserve has not negatively impacted stock markets, challenging the belief that high interest rates and quantitative tightening are bad for stocks.
In past instances, stock markets performed well with high interest rates and during quantitative tightening periods.
The relationship between net liquidity and future stock market returns is more complex than a single variable can capture.
Net liquidity, as measured by changes in bank reserves, explains only about 3% of S&P 500 returns.

Stock Market Performance and Bank Reserves

55:07 - 1:02:24

Only 3% of the S&P 500 returns are explained by changes in bank reserves.
Visual correlations explain between 3% and 10% of the variability of S&P 500 returns.
Changes in bank reserves do not correlate well with changes in S&P 500 returns because banks do not buy stocks with their reserves.
Banks primarily buy Treasuries, corporate bonds, and mortgage-backed securities with their high-quality liquid books.
Portfolio rebalancing has a marginal effect on stock prices but is not strong enough to cause significant declines.
Interest rates at zero can justify higher multiples on the S&P 500, while rates at 5% make lower P/E ratios less sensible.
Inflationary trends have been weak recently, indicating a soft patch of growth and potential for a Goldilocks environment.
Assets that perform well in this environment include growth stocks and bonds.
The Fed's quantitative tightening (QT) may lead to increased bond issuance but should not derail bond performance.

Bond Performance and Economic Outlook

1:02:05 - 1:09:13

Bonds have been flat-ish for the year due to growth surprising on the upside and the Fed reprising away the market from cutting rates.
Inflation expectations have come in aggressively, causing bond yields to remain high.
Stocks have performed better than bonds due to re-rating of growth and multiple expansions.
As we enter the lag time between 13 and 21 months, there is optimism in equity markets with a solid earnings per share growth estimate for 2024.
Bonds should be considered in portfolios as they can do well in disinflationary trends and protect against credit events or recessions.
The cost of buying calls for protection against credit events or recessions is now as cheap as before the banking crisis, indicating confidence that such events will not occur.
Investing against market pricing and consensus is important, considering optionality that protects against credit events or recessions.
Many cuts have been priced out, making it a better trade with improved pricing for 2024 bonds.
Timing a recession is difficult, but based on historical lag times of monetary policy tightening, early next year or end of this year could be when it hits.

Monetary Policy and Market Performance

1:08:59 - 1:12:39

Monetary policy tightening is expected to happen at the end of this year or early next year.
There is uncertainty about the exact timing and the possibility of a credit event in the meantime.
Bonds have historically underperformed equities due to equities having a higher beta and uncapped returns.
However, on a volatility-adjusted basis, bonds may have a window to outperform equities in the next six months.
The market will likely anticipate an economic recession before it officially happens.
There is a chance that bonds could perform better than equities in terms of volatility-adjusted returns over the next six months.