A couple of weeks ago, I used a study by Edward Leamer to show that a recession in the US in the next 12 months is highly likely. Similarly, in the UK and Europe, a recession is likely as well. The upcoming data for third quarter GDP growth is probably going to be still slightly positive, but weak and it could well be negative. Since the last two recessions (the Global Financial Crisis in 2008 and the pandemic in 2020) were extremely deep, many – especially younger – investors fear it is going to be another deep recession. Well, I don’t think so.
First, we must consider who will be hit by this recession. Yes, consumers will reduce spending given the enormous increase in energy and food prices. And the housing market will weaken because of higher mortgage rates. But be aware that compared to 2008, households today are in much better financial shape. Not only are there still some excess savings available for many middle and upper-middle class households from the pandemic days, but the debt they have to service is today quite a bit lower than in 2008. After the housing crisis, households spent many years reducing their debt loads and improving their financial position. And that will help us in the coming recession.
No, the problem in the coming recession will be corporate debt. Thanks to persistently low interest rates, many companies have increased their debt levels since the financial crisis. In the US, this trend was particularly strong and corporate debt excluding financial companies is now higher there than household debt. In the UK, corporate debt levels have not risen that much but are still quite high.
Debt levels in the UK and US
Higher interest rates are going to hit corporations badly and will force them to reduce investments, pay back debt, and de-lever their balance sheets.
The good news is that this is what happens in any normal business cycle recession. Some businesses will be over-levered and will go under. Others will have to reduce their debt load and repair their balance sheets. But as Oscar Jorda and his colleagues have demonstrated for a set of 17 developed countries, such episodes of corporate debt overhang do not lead to the deep recessions that we have seen in the aftermath of a housing crisis. The chart below shows the average change in GDP per capita of a country when corporate debt levels decline after a period of fast-rising debt levels. In comparison, it also shows the same data for the aftermath of fast-rising household debt. As you can see, the aftermath of corporate debt booms is much more benign with GDP declining for one year and then recovering pretty quickly again.
So, unless something unexpected happens and we do get a major financial crisis again, I am not too worried about the coming recession. It is probably going to look very similar to the 1990/1991 recession and not like the 2009 or 2020 recessions at all.
GDP/capita in the aftermath of corporate and household debt booms
Source: Jorda et al. (2020)