Markets : Is a recession or a banking crisis in the works?

Economic outlook - 15/02/2016

Investors are wondering if the pitiful performance by stock markets at the start of the year will stall economic growth.

In addition to worries about the slowdown in China and slumping oil prices, they are now contemplating the risk of a recession in the USA and of a banking crisis sparked by failing oil companies. Are these two risks worth losing sleep over?



An economic recession is, by its
very nature, always possible. And the risk must never be downplayed, in part because it could be caused by an
exogenous event. A recession can also be the result of an overheating economy. A
number of signs do indeed point to the latter:

1. The manufacturing sector is already contracting (see the 25 January 2016 issue of Macro Highlights & Strategy)
2. Corporate lending conditions are tightening
3. The bond markets are starting to price in a recession

> Nominal interest rates are very low
> Inflation expectations are extremely low
> The yield curve is flattening (see left-hand chart)
> Credit
spreads are high (see right-hand chart)


Yet there are more – and weightier – indications that the economy is not overheating:

1. The construction and property sectors are in full swing
2. Fiscal policy is increasingly accommodative
3. Consumer spending (65% of GDP) is rock solid

> Job creation is firmly positive
> Wage growth is picking up speed (see left-hand chart below)
> Inflation is very low
> Consumer debt has declined in recent years
> Both mortgage and consumer lending are dynamic (see right-hand chart below)


The likelihood of a recession in the USA cannot be completely ruled out but is extremely low (see chart on the first page). In a recent hearing before the US House Committee on Financial Services, Janet Yellen made this same point. The economic situation in the USA is not perfect, but the core scenario remains intact: "if [current financial conditions] prove persistent, [they] could weigh on the outlook for economic activity…[but] ongoing employment gains and faster wage growth should support the growth of real incomes and therefore consumer spending". The Fed chair would like to continue raising key interest rates, but the timing will depend on how the economy is faring. Her stance remains data dependent.

The second concern is the systemic risk of a domino effect of bank failures, which nearly happened in 2008 during the subprime crisis. Are oil companies in such financial straits as to imperil the system?

We do not think so, for a few reasons:

1. Debt levels are low

> Total
debt in the oil and gas sector is around 600 billion dollars, a far cry from
the 3.5 trillion dollars in mortgage debt at the start of the subprime crisis
in 2008.

2. The debts are not highly complex

> The sector's debt is straightforward, consisting mainly of bank loans and standard bonds. And the risk associated with the sector's bonds was not camouflaged by the packaging and repackaging of securities or multiplied by a leverage effect, both of which happened in 2008. These were high-yield bonds from the start, with a high default premium, whereas in 2008 the troubled bonds bore a AAA rating.

1. Energy is a small part of the equation

> The mining, oil and gas sector accounts for 2.3% of GDP, versus around 3.9% for construction and 13.3% for the property sector (see chart above).
> The energy sector is also much less labour intensive and employs a tiny fraction of the workforce.

2. Contagion channels are insignificant

> The oil boom was felt in only a handful of US states, whereas the property boom affected the entire country.