Equities

In previous posts, I’ve discussed our reasoning for why we believe the global economy is in the later stages of the business cycle. The next part of the cycle is a recession.

I’ve been discussing this risk since the start of the year when our macroeconomic model first began to raise yellow flags. In the meantime, all we can do is wait. But if we go through a recession, how big is the crash likely to be?

Main points

  1. Central banks have little 'firepower' to counter a recession and even less if they attempt to fight off slowing economic growth with lower rates.
  2. Corporate leverage has grown considerably. This makes the equity component of the corporate’s capital structure more volatile.
  3. Given how large US government deficits have become, it will require an even greater amount of fiscal stimulus to fight a recession which may be difficult to enact politically.

The central banking problem

When we examine historical recessions, we find that the magnitude of the stock market’s decline is somewhere in the order of 20-50%. The Great Depression was larger than this range (a circa 85% decline) because unsuitable fiscal and monetary policies were applied after the first stage of the crisis.

If we consider the GFC, the circa 50% decline was painful for stock investors and yet, adequate fiscal and monetary actions were applied such that said decline didn’t worsen.

The same logic can be applied to every recessionary period since the Great Depression. In short, governments and central banks learned that austerity/tight money measures were poor policies to apply at such times.

When the next recession arrives, central banks don’t have the monetary 'dry powder' they had in previous recessions and will likely fall into a liquidity trap. (For those new to macroeconomics, a liquidity trap is where the central bank has already made economic conditions so easy through monetary actions that any further action simply has no effect).

As such, without the ability to revive ‘animal spirits’ in the economy with easy money, it’s more difficult for policymakers to reverse any recessionary trends.

Further, with many expecting the Federal Reserve to slash rates over the coming months (to sure up economic growth in the near term), what little 'dry powder' is there may be even less when the recession arrives.

Corporate leverage

Consider the capital structure of a company via the following formula.

  • Enterprise value = value of equity + net value of debt

We can express enterprise value as a function of operating profits and the enterprise multiple (the enterprise multiple is a factor dependent on discount rates and projected growth rates).

  • Enterprise value = operating profits x enterprise value multiple

As the enterprise value falls either through lower profits or more pessimistic multiples, the value of equity is impacted - especially when there’s a lot of debt.

Consider the following example,

  • Enterprise value = $100
  • Value of equity = $50
  • Value of debt = $50
  • Operating profits = $10
  • Enterprise value multiple = 10x

Via a recession, say operating profits fall to $7 and the enterprise value multiple falls to 8. The enterprise value will thus fall to $56 ($7 x 8) from $100.

The debt value doesn’t change since the firm can still service its debts, yet the equity value falls from $50 to $6. A 44% decline in enterprise value has thus translated into an 88% decline in equity value. 

The effect is further magnified as the amount of debt rises relative to equity.

With corporates having leveraged up their balance sheets through a period of low rates, this condition is now a concern. Any weakness in economic profits will have a magnified effect on equity values.

US government spending

In 2018, the US government spent $4.2 trillion whilst taking in $3.3 trillion in taxes, meaning that the deficit was near $1 trillion.

What would the deficit look like if the government was fighting a recession?

Over the GFC, tax receipts in the economy fell by circa 19% and government expenditures rose by 12%. If we went into recession now and used the same numbers, what would the deficit look like? Estimated tax receipts would be $2.7 trillion and expenditures $4.7 trillion. Effectively this equates to a $2 trillion annual deficit (circa 10% of US GDP).

My numbers should be taken with a grain of salt because the growth of expenditures and fall in tax receipts may be different in future crises. But I don’t think that this is a bad set of numbers to start with.

Further, given that the central bank has less 'dry powder' than it had in the prior recession, perhaps the government would need to spend even more to make up the difference. As such, my $2 trillion deficit estimate could be on the conservative side.

Regardless, I think the government will be hard pressed to pass a $2 trillion deficit given the polarisation of modern politics. If they can’t pass it, there’s no shock absorber for any recessionary contraction and the US & global economy could sink into a major crisis.

And if the government can pass such a large spending bill, it will significantly impair the finances of the US government over the long term (unless they can print their way out of it ... which causes other problems).

Summing it up

Governments and central banks have some difficult choices to make and problems to solve in future which will likely create considerable volatility within financial markets. But with volatility comes the opportunity for patient investors to generate returns well beyond the levels of risk taken and this is exactly what we’re waiting for.



Comments

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S Leung

Most likely upon a recession few politicians would risk public ire by refusing to pass further deficits., and having seen the example of Europe going into negative interest the US may not hesitate as much. None of these are good things but the bottom of the barrel may be lower than what the writer suggests.