The underestimated risk of recession

The US economy is also doing well in the second quarter of 2024, driven by the boom in artificial intelligence, China, a technological leader in the field of electric cars, for example, is delighting the rest of the world with a huge export offensive, Germany is on the verge of an upswing, at least according to Chancellor Olaf Scholz, and interest rates will soon be falling everywhere. So everything is in the green, or is something being overlooked?

First of all, the picture for the major economies of the US, China and the eurozone actually looks pretty good since the end of 2021, considering that the war in Ukraine began in February 2022, which was certainly not a positive event. The colored dashed lines in charts 1-3 show the respective nominal economic growth, which reached over 10% in all three major regions by Q1 2024. However, it should not be overlooked that this growth was driven by even stronger growth in government debt, particularly in China, but also in the USA (gray lines in charts 1-3).

Only in the eurozone has the economy grown faster than government debt. However, it must be pointed out at this point that considerable creativity is used in the eurozone and in the EU when calculating government debt. For example, since 2010 there have been various rescue packages for Greece, Portugal, Ireland, Cyprus, etc., in which all EU member states are liable for the debts incurred, but the corresponding amounts do not have to be shown in the respective national debts. The same applies to the Federal Republic of Germany, which is supposedly extremely financially sound and does not show various special assets of €869 billion, of which €780 billion is loan-financed, in the official government debt (as at the end of 2022, source: Nordkurier, 10.3.2024). Net borrowing in 2023, a modest €45.6 billion according to official figures, would also be more than four times as high, at €192.8 billion, according to the Federal Audit Office. According to calculations by the Market Economy Foundation and the Research Center for Intergenerational Contracts at the Albert Ludwig University of Freiburg (Prof. Raffelhüschen), the largest amount is the implicit, i.e. invisible, national debt due to the unavoidable future federal subsidies for pension insurance and future civil servant pensions amounting to over 300% of German national income. China and the USA are also likely to have hidden government debt, but this may be particularly high in Europe.

The economies of China and the USA need rapidly growing government debt in order to generate any significant real economic growth, which unfortunately consists to an increasing extent of government spending. Despite accounting tricks, the eurozone probably achieves somewhat lower debt growth, but hardly creates any real economic growth. This finding of only weak growth in the private sector everywhere unfortunately coincides with the Leading Economic Indicators of the US research firm The Conference Board (TCB-LEI), which has been in the not-so-easy forecasting business since 1916 and therefore probably gets a lot right (for the high accuracy rate of the TCB-LEI for the USA since the 1950s, see the capital market outlook from June 2024, which you can find here ). The TCB-LEIs have been falling at double-digit rates since the end of 2021 and the beginning of 2022 (see charts 4-6), with no signs of a recession in the figures for the overall economy of the three regions, which also reflects the high level of government spending.

Now let's take a look at some real economic data from China. Residential construction, a strong pillar of the Chinese economy until 3 years ago, has since slumped by almost 60% (chart 7). Consumer confidence fell to a record low in February 2022 and has not recovered since (chart 8). Retail sales growth (5-year average) in China has fallen to its lowest level since this data was first collected (chart 9), with an average increase of just 3.3% in 2024.

It does not look like growth in the eurozone either. Productivity is stagnating, just as it did after the financial crisis in 2009 and during the coronavirus pandemic (chart 10), the sharp decline in the TCB-LEI for the eurozone is confirmed by the European Commission's business climate index, which is constructed differently and goes back to the 1980s (chart 11), and lending to private households is stagnating, comparable to the euro crisis from 2011 to 2013 (chart 12). This all confirms the statement in chart 3, according to which the economy in the eurozone is barely growing in real terms.

In one area, however, the eurozone has an advantage over the other two major regions. In China, consumer confidence is extremely low (chart 9). In the US, too, it is below the average value of all recessions since 1961 (chart 14), i.e. by no means at boom level. One of the reasons for this is the fact that Americans have long since spent their additional savings of USD 2,000 billion, which they were able to accumulate with the lavish coronavirus aid from the US government (chart 13). In the eurozone, savings remained high even after the coronavirus pandemic, with over EUR 1,800 billion still waiting to be spent (chart 15). Accordingly, consumer confidence in the eurozone has risen sharply since the record low of 2022, when it also reached its lowest level in the US (chart 16). In contrast to the US, it is currently well above the levels reached during the recessions of recent decades. Unlike in the US and China, consumption could therefore become a pillar of the eurozone economy in the future.

New construction is also unlikely to stimulate the US economy in the future. New construction activity in the commercial sector has slumped by 75% since the third quarter of 2022 (chart 17). Since the beginning of 2023, default rates on mortgage-backed securities have risen sharply (chart 18), making financing for such projects more difficult as banks are less willing to lend as a result.

A boom in residential construction is also likely to be a long time coming. The number of new housing starts has fallen by 26% since April 2022 (chart 19). In view of the unattractiveness of house purchases, which is measured by the Affordability Index (chart 20), new construction is unlikely to pick up again until mortgage interest rates (chart 21), which are a component of this index alongside record-high house prices (source: US Federal Reserve Bank of St. Louis) and per capita income, fall significantly.

The consumption of an economy can be financed from three different sources. The most convenient way is to draw on existing savings from previous years' income.

This is unlikely to be a particularly productive source, as the high savings from the coronavirus aid have already been used up as mentioned above (chart 13) and the savings rate was not very high even before the coronavirus pandemic and then almost as low as before the financial crisis from 2008 and just as low as before the bursting of the internet and telecoms bubble in 2000 (chart 22).

Consumption can also be paid for out of current income. In addition to the currently very low savings rate, however, falling wage growth and the incipient weakness of the US labor market with a decline in job vacancies from 12 to 8 million (chart 23) indicate that current income is also unlikely to fuel a consumption boom. The probability that the unemployment rate (April 2023: 3.4%, June 2024: 4.1%) will continue to rise significantly has increased significantly. The labor market has been a reliable early indicator of recessions for over 70 years. Whenever the average unemployment rate of the last three months exceeds the previous low of the unemployment rate by at least 0.33 percentage points, a recession has begun or the US economy is already in the midst of one (red dots in chart 24 always lie within a gray bar). This indicator last hit a 3-month average of 3.87% in April 2024 (0.37 percentage points above the unemployment rate of 3.5% in July 2023). Should a recession actually occur, the unemployment rate will continue to rise significantly (blue line in the gray bars) and weigh on consumption.

The final source of consumer finance, namely taking out consumer loans that are repaid from future income, does not bode well either. As already mentioned, mortgage rates, which have risen from just under 3% to 7%, are causing considerable problems for homebuyers (charts 20 and 21), although these rates are not very high by long-term standards. However, at almost 22% interest, taking out consumer credit with a credit card is more expensive than ever before (chart 25); even in the early 1980s, interest rates were "only" 19%, i.e. slightly higher than mortgage rates. As a result, many credit card borrowers are finding it difficult to service these loans. The default rate for the more than 4,000 smaller US banks is now almost 8%, the highest level since this data has been collected (1991). For the 100 largest banks, the default rate on credit card debt was just over 3%, the highest level since the first quarter of 2012.

A consumption boom in the USA is not to be expected from savings, higher current income or rising borrowing.

Even if the risk of recession in Europe is somewhat lower than in the US due to the better financial situation of consumers, it should nevertheless be noted that US recessions since 1970 have regularly led to price losses not only for US equities, but also on the European stock market. It may come as something of a surprise, but until the end of the euro crisis in 2013, share price trends in Europe and the US differed only minimally; it was only after this that the US stock market began to outperform strongly (chart 27). After the start of the eight recessions since 1970, both US and European share prices initially fell continuously (chart 28) and during the US recessions, prices fell by an average of -20.6% compared to the month before the start of the recession, which was even greater for European shares than for US shares (-19.1% on average). It is therefore unlikely that a US recession will be irrelevant for European equities.

In addition, US equities have risen significantly more than European equities since 2012 (charts 27 and 29), partly due to the economic policy events since the financial crisis of 2008 to 2009. The euro crisis began in 2011, preceded by the rescue packages for Greece, Ireland and Portugal that became necessary in 2010. In 2011, interest rates also rose sharply in the much larger countries of Italy and Spain and the eurozone economy fell back into recession, while the USA recovered strongly. Then came Brexit and the election of Donald Trump as US president. This gave US equities a further boost as Trump slashed corporate taxes. Europe, on the other hand, suffered from Trump's threats to use tariffs to protect US industry from foreign and therefore also European competition. After all, the war in Ukraine is a greater threat to Europe than to the US. If Kamala Harris becomes US president, European equities and the euro are likely to benefit. The latter also suffered from the aforementioned political events (chart 30).

The euphoria surrounding artificial intelligence (AI) is mainly taking place on the US stock market and explains a significant part of the current overvaluation (charts 31 to 35), but there is increasing thought that many other companies that do not produce AI systems, but are beginning to use them, will also benefit.

However, the fact that European equities are valued much more favorably than US equities (chart 31) and have earnings expectations of +8% p.a. instead of -2% p.a. for the next 10 years (charts 32 and 33) is unlikely to provide protection against the consequences of a not unlikely US recession in the short term, any more than a Trump election defeat.

If we then consider that the share of equities held by US private investors, and thus their optimism, is at its highest level since the US Federal Reserve began collecting this data in 1947 (!) (chart 34), we should perhaps be a little more cautious. Here, too, there is a close and logical correlation with future yields, which are likely to be well below zero by 2034 (chart 35).

Except during the equity bubble in 2000 (China, eurozone) and the first oil crisis (USA from 1974), when the TCB-LEIs rose in contrast to share prices, both lines mostly moved in parallel (green areas in charts 36 to 38). However, TCB-LEIs have never fallen sharply and share prices have risen at an above-average rate at the same time, as has been the case in the USA and Europe for the past two and a half years.

‍Conclusion :

The special thing about the current situation on the US stock market is that it is extremely expensive for the third time since 2000 (internet and telecoms bubble) and 2021 (TINA bubble: There is no alternative - meaning the historically low interest rate, also in the US), but:

• as the only stock market worldwide, unlike 2000 or 2021
• in a much worse overall geopolitical situation than in 2000 and 2021
• in a worse economic situation than in 2000 and 2021, when the global economy was booming (2000) or recovering strongly after the coronavirus lockdowns (2021); in both cases, the TCB-LEIs had risen up to the peak of share prices in the US and Europe. This time, however, there are clear signs of an economic slowdown in the major regions of the US, China and the eurozone, which may not be able to be countered with new government spending as usual due to the sharp increase in government debt

Due to the close links between the US and European economies and capital markets, problems on the US equity market will also be felt on the European equity markets. We should therefore no longer overweight equities and focus more on defensive sectors (healthcare, consumer staples).

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As usual, we will provide the key messages from our capital market outlook from 3 years ago here so that you can get a feel for our long-term forecasts.

The Capital Market Outlook from July 2021 can be found here. In it, we examined the inefficiency of the German welfare state and the resulting high implicit government debt, which leads to higher government debt in Germany compared to Italy, without the majority of Germans being able to accumulate significant wealth Their wealth situation looks poor compared to the other eurozone countries.

We also warned of a global overvaluation of equities. In fact, both the US S&P 500 share index and the Eurozone Eurostoxx 50 share index fell by just under 20% by the fall of 2022.

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You can also download the capital market outlook here.