Coronavirus and Economic Cycles - Is a recession here? I think Yes
Hi
Welcome back! Apologies I have not posted since early 2019.
If you have not yet read my post during the bear market at the end of 2018, I would highly recommend having a browse through that first as it contains information about how debt/ credit cycles operate.
2018 Blog Post.
Although I cannot time the market, at the end of 2018 I had noticed we were at the end of the long term and short term debt cycles (see 2018 Post above). However, I also thought that at that time it was a short term bear market (via technical analysis and yield curves). So what has changed since the end of 2018 that made me reconsider whether the recent coronavirus developments will trigger a full-blown recession?
DISCLAIMER: The information on this Blog doesn't constitute personal financial advice.
Is Coronavirus the Cause of the Upcoming recession?
In my 2018 post, I highlighted that US private debt to GDP is at all-time highs since the Great Depression in the 1930s, which is simply unsustainable. This has not changed.
Similar to the debt-fueled 1930 Depression, 2000s dot com bubble, and 2008 subprime mortgage, I believe the current situation is no different.
Let me clarify. Although I do acknowledge and agree that the coronavirus outbreak has severe economic implications, effectively stopping the flow of cash due to lockdown and restrictions, I think the coronavirus breakout is not exactly the CAUSE of economic turmoil. It is only the catalyst that triggered the collapse of a debt-fuelled speculative bubble (the same one as previous economic recessions).
In other words, there was underlying fundamental weakness in the economy, and all it took was a small trigger to expose this. However, the COVID-19 pandemic was a MASSIVE trigger, resulting in lockdowns and stopping income streams.
The True Cause
I believe the underlying reason behind economic downturn is debt.
Debt itself isn't bad, however, poorly managed debt is the true issue. With interests rates at record lows, an increasing number of companies and individuals have been able to use leverage to boost their earnings. The issue with this is that poorly managed businesses were also able to secure these loans.
The majority of business debts in the USA currently is rated BBB, which is far from ideal.
Thus, any complication with cash flow even for a few days or weeks would amount to a disaster, let alone a crisis such as the COVID-19 outbreak which effectively stops the flow of cash for an extended period.
These businesses coined 'zombie companies' were surviving on indiscriminating cheap credit due to record low-interest rates. However, even BEFORE the COVID-19 crisis they were barely surviving, only generating enough cash to cover interest payments, not principal. Latest estimates by the OECD places around 12% of Australian businesses and 16% of US businesses in this 'zombie category'.
These companies along with other financially unstable businesses will not have the capacity to survive their loan repayments and obligations due to decreased demand from the COVID-19 restrictions and thus will default. Employees lose their jobs and they themselves will not be able to meet their debt obligations (e.g. mortgages). Spending decreases and consequently the flow of cash decreases putting even more businesses at risk and the cycle continues.
Drawing analogies, the economic crisis of 2008 was caused by people borrowing more money than they can afford and that was set off by banks falling into liquidity issues. The current crisis is caused by businesses and people borrowing more than they can afford, set off by the complete stop of cash flows due to Coronavirus restrictions.
What has changed since the end of 2018 that makes me believe we are going to be in recession very soon?
Yield Curves
The importance of yield curves is explained my 2018 article. The 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity went negative in August 2019 which historically indicates a recession was very near.
Interest Rates
Interest Rates have also hit rock bottom and cannot be pushed any lower to promote spending.
Thus I believe this crisis is when the economic turmoil will begin as opposed to my 2018 article when interest rates were still able to be decreased and the 10-2 Year treasury had not yet hit 0.
US and Australia Analysis
For the USA, please refer to household debt to GDP above. Record levels of debt means repayment obligations. Coronavirus restrictions will expose these fundamentally weak companies which can no longer rely on debt to stay solvent and thus will go bankrupt. In the process many jobs will be lost and individuals will have difficulty meeting their debt obligations. Spending will decrease and consequently, cash flow will also decrease continuing the downward spiral.
As I am from Australia, I would like to expand more on my perspective for Australia. My major concern is the Australian property market. Due to a range of factors including tax legislation favouring property investments over other asset classes, skill migration from other countries increasing demand for housing etc. the Australian housing market has been one of the most profitable investments.
However, upon looking at the fundamentals, we begin to see the risks of the housing market. It is effectively driven by income and credit. If people have a solid source of income they will qualify for loans and will increasingly be able to purchase a property, increasing demand and thus prices. The issue is that wage growth has become stagnant in many countries around the world including Australia. So with income no longer being a driver, the housing market has been driven up based on DEBT.
As explained above, with record low-interest rates, more and more people have been able to qualify for housing loans and the Australian household debt to GDP has ballooned.
With the country being placed in lockdown and the flow of cash stopping, the issue with debt-driven growth rather than fundamental-driven growth will be felt. Already many businesses that aren't as financially sound have gone bankrupt and tens of thousands of jobs have been lost. This further reduces spending and cash flows as people will struggle to meet their debt obligations, causing an economic downturn.
Conclusion
I believe we are heading into recession (or are already in one). I will be investing in inverse ETFs to short the market in the short term while investing in quality companies at bargain prices to prepare for the economic expansion after the crisis has run its course as the recovery will yield some great profits in the long run.
I will provide updates on the blog.
Thank you.
Howard
Welcome back! Apologies I have not posted since early 2019.
If you have not yet read my post during the bear market at the end of 2018, I would highly recommend having a browse through that first as it contains information about how debt/ credit cycles operate.
2018 Blog Post.
Although I cannot time the market, at the end of 2018 I had noticed we were at the end of the long term and short term debt cycles (see 2018 Post above). However, I also thought that at that time it was a short term bear market (via technical analysis and yield curves). So what has changed since the end of 2018 that made me reconsider whether the recent coronavirus developments will trigger a full-blown recession?
DISCLAIMER: The information on this Blog doesn't constitute personal financial advice.
Is Coronavirus the Cause of the Upcoming recession?
In my 2018 post, I highlighted that US private debt to GDP is at all-time highs since the Great Depression in the 1930s, which is simply unsustainable. This has not changed.Similar to the debt-fueled 1930 Depression, 2000s dot com bubble, and 2008 subprime mortgage, I believe the current situation is no different.
Let me clarify. Although I do acknowledge and agree that the coronavirus outbreak has severe economic implications, effectively stopping the flow of cash due to lockdown and restrictions, I think the coronavirus breakout is not exactly the CAUSE of economic turmoil. It is only the catalyst that triggered the collapse of a debt-fuelled speculative bubble (the same one as previous economic recessions).
In other words, there was underlying fundamental weakness in the economy, and all it took was a small trigger to expose this. However, the COVID-19 pandemic was a MASSIVE trigger, resulting in lockdowns and stopping income streams.
The True Cause
I believe the underlying reason behind economic downturn is debt.
Debt itself isn't bad, however, poorly managed debt is the true issue. With interests rates at record lows, an increasing number of companies and individuals have been able to use leverage to boost their earnings. The issue with this is that poorly managed businesses were also able to secure these loans.
The majority of business debts in the USA currently is rated BBB, which is far from ideal.
Thus, any complication with cash flow even for a few days or weeks would amount to a disaster, let alone a crisis such as the COVID-19 outbreak which effectively stops the flow of cash for an extended period.
These businesses coined 'zombie companies' were surviving on indiscriminating cheap credit due to record low-interest rates. However, even BEFORE the COVID-19 crisis they were barely surviving, only generating enough cash to cover interest payments, not principal. Latest estimates by the OECD places around 12% of Australian businesses and 16% of US businesses in this 'zombie category'.
These companies along with other financially unstable businesses will not have the capacity to survive their loan repayments and obligations due to decreased demand from the COVID-19 restrictions and thus will default. Employees lose their jobs and they themselves will not be able to meet their debt obligations (e.g. mortgages). Spending decreases and consequently the flow of cash decreases putting even more businesses at risk and the cycle continues.
Drawing analogies, the economic crisis of 2008 was caused by people borrowing more money than they can afford and that was set off by banks falling into liquidity issues. The current crisis is caused by businesses and people borrowing more than they can afford, set off by the complete stop of cash flows due to Coronavirus restrictions.
What has changed since the end of 2018 that makes me believe we are going to be in recession very soon?
Yield Curves
The importance of yield curves is explained my 2018 article. The 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity went negative in August 2019 which historically indicates a recession was very near.
Interest Rates
Interest Rates have also hit rock bottom and cannot be pushed any lower to promote spending.
Thus I believe this crisis is when the economic turmoil will begin as opposed to my 2018 article when interest rates were still able to be decreased and the 10-2 Year treasury had not yet hit 0.
US and Australia Analysis
For the USA, please refer to household debt to GDP above. Record levels of debt means repayment obligations. Coronavirus restrictions will expose these fundamentally weak companies which can no longer rely on debt to stay solvent and thus will go bankrupt. In the process many jobs will be lost and individuals will have difficulty meeting their debt obligations. Spending will decrease and consequently, cash flow will also decrease continuing the downward spiral.
As I am from Australia, I would like to expand more on my perspective for Australia. My major concern is the Australian property market. Due to a range of factors including tax legislation favouring property investments over other asset classes, skill migration from other countries increasing demand for housing etc. the Australian housing market has been one of the most profitable investments.
However, upon looking at the fundamentals, we begin to see the risks of the housing market. It is effectively driven by income and credit. If people have a solid source of income they will qualify for loans and will increasingly be able to purchase a property, increasing demand and thus prices. The issue is that wage growth has become stagnant in many countries around the world including Australia. So with income no longer being a driver, the housing market has been driven up based on DEBT.
As explained above, with record low-interest rates, more and more people have been able to qualify for housing loans and the Australian household debt to GDP has ballooned.
With the country being placed in lockdown and the flow of cash stopping, the issue with debt-driven growth rather than fundamental-driven growth will be felt. Already many businesses that aren't as financially sound have gone bankrupt and tens of thousands of jobs have been lost. This further reduces spending and cash flows as people will struggle to meet their debt obligations, causing an economic downturn.
Conclusion
I believe we are heading into recession (or are already in one). I will be investing in inverse ETFs to short the market in the short term while investing in quality companies at bargain prices to prepare for the economic expansion after the crisis has run its course as the recovery will yield some great profits in the long run.
I will provide updates on the blog.
Thank you.
Howard
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