10 years since the GFC: is recession due?

Spotlight 15 September 2017

It’s been a decade since financial crisis gripped the world. Mark Rider considers what’s next.

On August 9, 2007 French bank BNP Paribas froze $US2.2 billion of money-market funds. Many consider it to be the event that marked the start of what we now know as the global financial crisis. Over the next 18 months, share and credit markets tumbled, and the world economy experienced the worst recession since the 1930s.

Ten years on, the recovery has been remarkable. In fact, the sustained strength of world sharemarkets and economies since 2009 is now itself a source of concern – just how long can this expansionary phase continue?

If we look at the United States, its current bull sharemarket and economic recovery is approaching a decade-long run, last seen in the 1990s. Its leading sharemarket index, the S&P 500, has also been very strong despite slower economic growth.

How much longer can it go on?

Indications that a bull sharemarket is ending (usually flagging a recession) are imbalances such as very low unemployment or high debt, and excessive confidence in the market. But today, current overall valuations are less extreme than previous market peaks in 2000 and 2007.

A useful way to picture overall valuations and how they’ve tracked through previous cycles, is by combining various measures into one, focused on risk premiums. By putting term, credit and equity premiums together, we can get a good sense of how investors are pricing investment risks and what this means for the market in the months ahead.

The chart shows market pricing of these risks relative to the risk-free rate (that is, cash).

Market risk premiums – total

Source: JP Morgan, Thomson Reuters Datastream, ANZ Wealth

The chart indicates that the combined risk premiums are close to the average of the past three decades. ‘Average’ means we’re not likely to enter a bear market and recession anytime soon. Investor perception of risk will need to fall further before then rising, signalling a bear market and recession is at hand.

Similarly, such factors as margin debt and global equity fund flows, which are good indicators of investor sentiment, are positive but not at the extreme level that would suggest excessive exuberance and that a market peak is imminent.

However, there are emerging signs of risks in high debt and low unemployment in developed economies.

Outside of the financial sector, US corporate net debt is flashing red. It’s 1.9-times corporate earnings, higher than the previous two cycles. But other important corporate readings, such as capital expenditure and merger activity, remain restrained. So, we’re not yet facing the typical surge characteristic at the end of an investment cycle.

For economic indicators, the current US unemployment rate of 4.3 per cent is typical of a peaking market, suggesting end-of-cycle risks from high inflation and tight monetary policy. But lending standards show we are far from this point, with banks supportive of the US economic expansion and markets. And inflation remains below 2 per cent and isn’t threatening to go much higher anytime soon.

Keep an eye on China

So while the current investment and economic cycle has been lengthy, we don’t see enough typical signals to suggest an end is imminent.

For now, ANZ’s chief investment office continues with its strategy of growth assets at benchmark – valuations still have further to rise if history is to repeat, sentiment is far from exuberant and corporate behaviour restrained.

But every cycle is different and we need to keep an eye on what that difference may be this time. In terms of financial and economic risks, at the top our list is China due to its increasing debt since the global financial crisis. With the increased importance of emerging markets, including China over the past decade, it may well be the source of the next major market shock, although there are no signs of this at present.