What Will Cause the Next Recession?

A decade on from the beginning of the global financial crisis, Emma Wall talks to Rathbone's Ed Smith about what may cause the next downturn

Emma Wall 23 August, 2017 | 7:39AM
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Emma Wall: Hello, and welcome to the Morningstar series, "Market Reaction." I'm Emma Wall and I'm joined today by Rathbones', Ed Smith, to talk about the 10-year anniversary of the financial crisis.

Hello, Ed.

Edward Smith: Hello, Emma.

Wall: So, cast your mind back to 20007, a lot has happened since then, both from an economic level, from a central bank level and indeed, from an asset price level. So, how far have we come?

Smith: Well, certainly, from an asset price level, we've come quite a long way. Now, how far have we come in terms of economics, the earnings that underlie those asset prices, well, I think it very much differs from region to region. Remember the financial crisis was caused by excess risk taking and excess debt and the mispricing of risk and the mispricing of debt and what assets you might have to hold to balance off those debts.

I think in the U.S. and the U.K. we've come quite a long way. I think we should see regulation in the banking sector as a big positive. Yes, it probably means that the boom times are going to be less booming from now on. Banks can't extend the loans to the extent that they used to. But if the trade-off there is less risk of a financial crisis, more stability, less risk of insolvency, then I think that's a good thing.

Unfortunately, we are seeing a bit of a rise in corporate leverage again. Now, remember, in the nonfinancial sector going into the financial crisis corporate leverage wasn't really a problem. In the U.S., we are seeing the median leverage – or the leverage of the median S&P 500 companies reach sort of new highs. And that's a little worrying. Are companies taking their eyes off growth, earnings growth and putting it and focusing too much on the shareholder returns, borrowing to fund buybacks? I think that's an important question.

But yeah, so asset prices have come a long way; economics has recovered, earnings have recovered, but I think we have still got some way to fix the period of anemic growth.

Wall: So, then, I suppose the next question is, are we on the cusp of another? Because we have enjoyed as shareholders, as asset holders, significant returns since the bottom out in 2009 and you say that there are some concerns about medium-sized companies in the U.S. leveraging up. So, does this mean that we are sitting again on the brink of another crisis?

Smith: I don't think we are sitting on the brink of another crisis, but I think that rise in corporate leverage does increase the likelihood that the next recession is going to be a very boring, very traditional one from a historian's point of view.

It would probably be caused by central banks raising interest rates a little too much, squeezing companies a little too much, eroding the incentive to invest and spend and causing a recession. That's the traditional cause of a recession. I don't think it's going to be a financial crisis. Because it's never easy to say with foresight, but we're not seeing clear pockets of excess of opaque transactions in certain areas, slicing and dicing of risk and debt.

Some people are very concerned about the asset-backed securities market in auto loans in the U.S. We've had a good look into that. It is just not of the size and scale of mortgage-backed securities. It really isn't. So, don't believe those headlines and there's far less re-securitization of those loans as well. So, I think the next recession is going to be a boring one, not a financial crisis.

Wall: And of course, rising interest rates don't just squeeze overleveraged corporates either, do they? They have an impact on households, on those individuals who have mortgage debt?

Smith: Yes. And you got to wonder if the consumer is going to be a little more sensitive to rising interest rates this time around. Particularly, in the U.K., we know that housing has become a lot less affordable.

We know that people are spending a lot more off their personal income servicing mortgages. So, that certainly is something to watch this time around. Again, banks are doing far fewer weird and wonderful things with those mortgages, with those credit card loans.

There's far less slicing and dicing. The risks are less opaque. And of course, regulators, as we started our conversation, have forced banks to become a lot more prudent, hold a lot more capital in reserves. So, even if the consumer is a little more sensitive, defaults are a little higher this time around, it still shouldn't translate into a financial crisis.

Wall: Ed, thank you very much.

Smith: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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