Why Soaring Assets And Low Unemployment Mean It’s Time To Start Worrying
Today’s conditions expose vulnerabilities that make a recession or market meltdown more likely.
By Greg Ip
The Wall Street Journal
July 6, 2017
If you drew up a list of preconditions for recession, it would include the following: a labor market at full strength, frothy asset prices, tightening central banks, and a pervasive sense of calm.
In other words, it would look a lot like the present.
Those of us who have lived through economic mayhem before feel our muscle memory twitch at times like this. Consider the worrisome absence of worry. “Implied volatility” measures the cost of hedging against big market moves via options. When fear is pervasive, options are expensive so implied volatility is high. At present, implied volatility in bonds, stocks, currencies and gold sits near its lowest since mid-2007, the eve of the financial crisis, according to a composite measure maintained by Variant Perception, a London-based investment advisory.
The economic expansion is now entering its ninth year and in two years will be the longest on record. The unemployment rate sits at 4.3%, the lowest in 16 years, suggesting the economy has reached, or nearly reached, full capacity.
Expansions don’t die of old age, economists like to say. On the other hand, should we really assume this one will be a record breaker? From a level this low, unemployment has more room to go up than down. Another ominous sign: Central banks are tightening monetary policy, which has preceded every recession. The Fed has raised rates three times since December and last week central banks in Britain, the eurozone and Canada all hinted that years of easy money were coming to an end.
Still, the presence of recession preconditions isn’t enough to say one is imminent. To understand implied volatility, think of hurricane insurance. Right after a storm, homeowners are more anxious to have coverage, even as insurers withdraw, which of course means premiums spike. As years go by without another hurricane, homeowners let their coverage lapse, insurers return and premiums drop. Similarly, implied volatility is low today because years without a financial calamity have sapped demand for hedging while enticing sellers with the prospect of steady income in exchange for potentially huge losses. But just as hurricane premiums don’t predict the next hurricane, low implied volatility tells us nothing about whether or when a downdraft will actually come.
Similarly, when unemployment got nearly this low in 1989 and again in 2006, a recession was about a year away; but in 1998, it was three years away, and in 1965, four years. A narrowing spread between short-term interest rates and long-term rates comparable to the present has happened 12 times since 1962, and only five times did recession follow within two years.
But if today’s conditions don’t dictate a recession or a market meltdown, they expose vulnerabilities that make either more likely in the face of some catalyzing event.
When growth is steady and interest rates are low for years, investors and businesses behave as if those conditions will last forever. That’s why even with muted economic growth, stocks are trading at a historically high 22 times the past year’s earnings. It’s also why home prices have returned to their pre-crisis peaks in major American cities. Real estate has scaled even greater heights in Australia, Canada and parts of China, which exhibit some of the same lax lending and wishful thinking that underlay the U.S. housing bubble a decade ago.
Companies meanwhile have responded to slow, stable growth and low rates by borrowing heavily, often to buy back stock or pay dividends. Corporate debt as a share of economic output is at levels last seen just before the past two recessions.
If you drew up a list of preconditions for recession, it would include the following: a labor market at full strength, frothy asset prices, tightening central banks, and a pervasive sense of calm.
In other words, it would look a lot like the present.
Those of us who have lived through economic mayhem before feel our muscle memory twitch at times like this. Consider the worrisome absence of worry. “Implied volatility” measures the cost of hedging against big market moves via options. When fear is pervasive, options are expensive so implied volatility is high. At present, implied volatility in bonds, stocks, currencies and gold sits near its lowest since mid-2007, the eve of the financial crisis, according to a composite measure maintained by Variant Perception, a London-based investment advisory.
The economic expansion is now entering its ninth year and in two years will be the longest on record. The unemployment rate sits at 4.3%, the lowest in 16 years, suggesting the economy has reached, or nearly reached, full capacity.
Expansions don’t die of old age, economists like to say. On the other hand, should we really assume this one will be a record breaker? From a level this low, unemployment has more room to go up than down. Another ominous sign: Central banks are tightening monetary policy, which has preceded every recession. The Fed has raised rates three times since December and last week central banks in Britain, the eurozone and Canada all hinted that years of easy money were coming to an end.
Still, the presence of recession preconditions isn’t enough to say one is imminent. To understand implied volatility, think of hurricane insurance. Right after a storm, homeowners are more anxious to have coverage, even as insurers withdraw, which of course means premiums spike. As years go by without another hurricane, homeowners let their coverage lapse, insurers return and premiums drop. Similarly, implied volatility is low today because years without a financial calamity have sapped demand for hedging while enticing sellers with the prospect of steady income in exchange for potentially huge losses. But just as hurricane premiums don’t predict the next hurricane, low implied volatility tells us nothing about whether or when a downdraft will actually come.
Similarly, when unemployment got nearly this low in 1989 and again in 2006, a recession was about a year away; but in 1998, it was three years away, and in 1965, four years. A narrowing spread between short-term interest rates and long-term rates comparable to the present has happened 12 times since 1962, and only five times did recession follow within two years.
But if today’s conditions don’t dictate a recession or a market meltdown, they expose vulnerabilities that make either more likely in the face of some catalyzing event.
When growth is steady and interest rates are low for years, investors and businesses behave as if those conditions will last forever. That’s why even with muted economic growth, stocks are trading at a historically high 22 times the past year’s earnings. It’s also why home prices have returned to their pre-crisis peaks in major American cities. Real estate has scaled even greater heights in Australia, Canada and parts of China, which exhibit some of the same lax lending and wishful thinking that underlay the U.S. housing bubble a decade ago.
Companies meanwhile have responded to slow, stable growth and low rates by borrowing heavily, often to buy back stock or pay dividends. Corporate debt as a share of economic output is at levels last seen just before the past two recessions.
When everyone acts as if steady growth and low volatility will last forever, it guarantees they won’t. Once asset prices fall, the flow of credit that sustained them dries up, aggravating the correction. Corporate leverage is at levels that in the past led to weakening corporate bond prices and greater equity volatility, says Jonathan Tepper, founder of Variant. “A high proportion of companies won’t be able to pay back debt.” A selloff in corporate bonds and stocks could become self-reinforcing as those who insured against such a move sell into it to limit their own losses.
Of course, some things are different this time. The post-crisis regulatory crackdown means if asset prices fall, they probably won’t take banks down with them. Last week Janet Yellen, the Fed chairwoman, said she thought there wouldn’t be another financial crisis “in our lifetimes.” Fair enough: crises as catastrophic as the last happen twice a century. But small crises are inevitable as risk migrates to financial players who haven’t drawn the attention of regulators. “Elevated asset valuation pressures today may be indicative of rising vulnerabilities tomorrow,” Fed vice chairman Stanley Fischer warned last week.
Inflation is uncomfortably low rather than too high as in previous cycles, which makes it less likely central banks will have to raise interest rates sharply or rapidly. But in a world with permanently lower inflation and growth, businesses will struggle to earn their way out of debt, and interest rates will bite at lower levels than before. This confronts the Fed with a dilemma. If bond yields remain around 2% to 2.5%, the Fed may be playing with fire by pushing rates to 3%, as planned. If it backs off those plans, it could egg on excesses that make any reversal more violent.
Ms. Yellen and Mr. Fischer, both veterans of past mayhem, need to be on guard for a repeat. So should everyone else.
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