CoStar Economy: The Tipping Point Can Be Tough to Predict
“As grains pile up, it seems clear that a broad mountain of sand should edge slowly skyward, and yet things obviously cannot continue in this way.”
– From “Ubiquity: Why Catastrophes Happen,” by Mark Buchanan
Who had war with Iran as one of their top five risk factors for 2020?
OK, now put your hands down, you liars.
That’s the hard part about risk. Try as you might, it’s very hard to predict where it might come from. And especially when it might pop up.
As we start 2020, the question we get most often, and here I’m speaking for your authors and economists at large, is when the next recession will happen. And we do the things that most people do, we look at the leading indicators, we look at…well, everything we can to get take a temperature of the economy, to get a picture of its health. You, reader, see the results of that work every week in this space.
The second-most popular question, and frankly the one we hate the most, is what will cause the next recession. It is far easier to craft a narrative around what happened during a previous one. A lucrative cottage industry sprouted explaining the housing and mortgage debt crisis. Remember the great charts of how a collateralized debt obligation works? Similar stories were told about the tech bust, the savings and loan crisis, and so on. They are always written after the fact.
That kind of post hoc analysis, while entertaining, makes everyone think that if they just try harder and look closer at the right data, they will be able to spot the reason behind the next collapse before it hits. However, that doesn’t seem to be the case in actual practice.
Every expansion goes through ups and downs, featuring serious threats that could push the economy into a recession. The current U.S. expansion has faced a variety of potential recession-makers, namely the Eurozone debt crisis (remember the PIIGS?) and the economic slowdown in Europe that followed. There is always some threat, there is always something to be worried about.
Why do some events “cause” a recession while the economy is strong enough to weather others?
There are a few mental models that are useful for this kind of thinking. I think the best one is explored in the book by Mark Buchanan from which the above quote is borrowed. In this lovely book, Mr. Buchanan explores a variety of hard-to-predict phenomenon such as earthquakes and wild fires and mass extinctions. But the discussion of the sand pile game remains the most useful. The thought experiment is simple: start by dropping a single grain of sand. Then drop another. Continue this process until a pile begins to form (the quote above should make more sense now).
In Buchanan’s words, “As the pile grows its sides become steeper, and it becomes more likely that the next falling grain will trigger an avalanche.”
In the book, a group of physicists want to study this thought experiment using computer models that could run simulations of millions of sand pile games. How much sand usually has to build up to cause an avalanche? How big is a “normal” avalanche? The surprising answer, after all the simulations, was that there isn’t an answer. Every avalanche is different. Every avalanche is essentially unpredictable.
This is an unsatisfying answer, even for a physicist.
The group then decided to change tactics, specifically their point of view. Looking at the sand pile from the top down, they could then shade sections of the pile based on how steep the grains of sand were. Green areas were less steep and mostly stable, while red indicated steep and unstable sections. This method gave the team something of an early warning indicator for upcoming avalanches. And how many red sections there were in the pile, and how connected they were to each other, also offered clues about the size of the upcoming avalanche.
Well this is a weird way to start a 2020 outlook column, isn’t it?
The point of all this, if you’ve stuck around long enough, it’s easy to blame an avalanche on that final grain of sand that fell and triggered the fall. But that would be wrong.
Just like it is easy to blame a recession on the last event that occurred that seemed to trigger it. But that would also be lazy analysis. That’s why trying to answer the question of “what is the thing that will cause the next recession” is a fools errand.
Every economic action, every person hired, every building built, every widget manufactured and sold is a grain of sand dropped on the pile. It’s our job to look at the pile and watch it grow. Or, more precisely, to watch how it grows.
Where are the imbalances? What sectors are growing in such a way that they are creating a critical state that might be more susceptible to collapse? How interconnected are these “red spots” in the economy?
Experience teaches that debt is often the leading cause of instability, or at least the most visible and measurable sign. Those who were early to warn of the residential housing bubble in 2005-2006 often pointed to the ratio of household mortgage debt to GDP as a sign of the bubble. Why not start there to look for clues? For that, we go to the Fed’s Flow of Funds data.
A few things stand out immediately. The run-up in single family mortgage debt taken on by households during the housing boom has almost completely reversed. Second, commercial real estate debt makes up a relatively small fraction of total debt outstanding in the U.S. economy, when compared to other kinds of debt. And at only 20.9% of GDP in the third quarter of 2019, the latest data point, it is still nearly 3% below its previous peak reached in 2009. Not bad! Whatever worries we may have about commercial real estate in 2020, too much leverage doesn’t seem to be one of them.
The last thing to notice is nonfinancial business debt. We aren’t breaking news to say there are concerns about too much debt on business balance sheets. Analysts have noted for years how this sector has continued to lever up during the economic expansion. Many have noted the aggressive growth in the collateralized loan obligation (CLO) market for corporate debt, often likening it to the growth in the various mortgage-related structured products that helped facilitate the financial crisis. Others have noted this build up in debt is a rational response to the extremely low cost of debt as the Fed cut rates to near zero. Much of the proceeds of this debt has gone to stock buybacks, effectively replacing high cost equity with low cost debt. Who will come out correct?
We won’t make any further prognostications on the corporate debt market here. This is CoStar, after all, and we aren’t in the business of analyzing corporate credit. But businesses are tenants, and they hire employees who live in apartments and shop in strip malls and on Amazon. So it bears monitoring this corner of the economic sand pile for collapse, and looking closely to see what other areas it might be connected to.
Don’t worry, you won’t be subjected to this kind of long-form think piece next week. Now that the holidays have run their course, the data is back!
And it will be a week to get an update on the state of nonfarm payrolls, so buckle up.
Ahead of Friday’s deluge of labor market data, on Tuesday we’ll get a new read on sentiment in December from the Institute for Supply Managment’s survey of the service sector (and we’ll also discuss last week’s ISM manufacturing survey at that time). These continue to be one of our most-watched indicators of the economy.