Corporate Credit, Housing, and the Next Recession

More than a decade ago, a financial crisis sparked in part by a burst housing bubble plunged the U.S. economy into recession. What might cause the next downturn?

Admittedly, economists have been bad at forecasting recessions, to say nothing of their ability to foresee the trigger. Unexpected events, such as the emergence of the coronavirus, can send markets and the economy into a tailspin.

Nevertheless, while our baseline forecast calls for a period of weakness to give way to a moderate recovery during 2020, it is worth asking what might kill the U.S. expansion, now in a record 11th year.

Here, we share two themes – focused on the potential causes of the next recession – from our latest outlook, “Seven Macro Themes for 2020,” which distills key points from our recent quarterly Cyclical Forum. We follow a suggestion by PIMCO advisor and Nobel laureate Richard Thaler to engage in a premortem – an exercise intended to mitigate groupthink and overconfidence in a particular baseline scenario.

In doing so, we asked our U.S. team to assume that the economy falls into recession in 2020 and suggest a plausible narrative of how and why this happened. The team zoomed in on vulnerabilities in the riskier segments of the corporate credit market that could exacerbate a slowdown of growth and turn it into a recession. The story goes as follows:

Potential cracks in the corporate credit cycle

In 2017 and 2018, due in part to a notable increase in nonbank loans to U.S. small and midsize firms that couldn’t get credit from banks, the corporate credit impulse (i.e., the change in overall credit flows, which is highly correlated with GDP growth – see chart below) accelerated dramatically. These firms benefited from strong global growth and U.S. fiscal stimulus and drove the acceleration in private-sector job growth. However, when GDP growth decelerated during 2019 from 3% to 2%, private credit lending ground to a halt and, in addition, banks tightened standards on commercial and industrial loans.

Sharp slowing of credit impulse suggests near-term downside risks to U.S. economic growthImage Pop Up

According to Federal Reserve data, private credit is a roughly $2 trillion market, or 9% of U.S. GDP, which makes a slowdown in this engine of credit growth seem manageable in the context of a robust labor market and healthy consumers.