In most developed economies, the post-war years since 1945 saw sustained business cycle expansions alternating with shorter recessions. At the end of each expansion, authorities dealt with inflation by raising interest rates and slowing credit growth. When inflation subsided, interest rates were lowered again.
So long as balance sheets remained broadly healthy, recovery occurred quite quickly as companies and households increased borrowing and spending in response to lower rates. However, when an expansion was accompanied by a bubble in asset prices and then a bust, the recovery process became more difficult and protracted because of the widespread damage to balance sheets.
What does this suggest for the current recovery in the US?
The financial sector: deleveraging
During the housing bubble of 2002 to 2007, more credit was created in the nonbank, or shadow banking,1 sector than in the bank sector. Since 2008, the banking sector has largely stabilized, while the shadow banking sector continues to shrink. The extensive repair of balance sheets required in the financial sector has unquestionably restrained the pace of US growth in this recovery. But looking forward, banks and shadow banks are approaching the end of the deleveraging phase.
Nonfinancial corporate sector: releveraging
While the tech bubble of the late 1990s was mainly a corporate phenomenon, nonfinancial corporates generally didn’t participate in the bubble of 2003 to 2008. As a result, balance sheets weren’t significantly damaged by the crisis of 2008 and 2009, and the recovery in the corporate sector has been fairly rapid.
Corporations are releveraging at a moderate pace, but they are unlikely to leverage up aggressively because — despite the combination of good cash flow and relatively weak investment trends since 2009 — corporate treasurers have remained risk averse. They are unlikely to commit to large-scale investments in the US until household balance sheets are more fully repaired and consumers return to pre-crisis rates of spending growth.
Household deleveraging: What will the future bring?
The most important difference between the 2003-to-2008 business cycle expansion and previous ones was the leveraging up of the US consumer sector for house purchases. Other developed economies’ experience with recovery from housing busts suggests that such balance sheet adjustments take an average of six to seven years, not just a few quarters.
There are two main reasons why consumer balance sheet problems take so much longer to fix than corporate balance sheet problems. First, unlike companies, consumers cannot raise new capital. Second, again unlike companies, it is difficult for consumers to sell assets and use the proceeds to pay down debt. This is because most consumers have borrowed to buy their primary residence, and naturally they do not want to sell. As a result, consumers must cut consumption, increase savings, and pay down debt gradually — year by year — out of savings. This is why it is taking so long for those economies that had housing bubbles to recover.
Given the magnitude of the recent US housing boom and the high levels of debt, it is not surprising that the balance sheet repair process has taken so long, and it may still take a year or two more to complete. Nevertheless, the US consumer is making more progress than consumers in either the UK or the eurozone. This helps to explain the relatively better performance of the US economy, and it points to continued improvements going forward.
Lesson for investors
The lesson for investors is that economic and stock market downturns following bubbles tend to be more severe than normal, and recoveries slower. However, in view of the good progress that the US is making in repairing balance sheets in the financial and consumer sectors, the US should continue to outperform.
1Shadow banks are nonbank financial intermediaries that provide services similar to those provided by traditional commercial banks, particularly credit creation, and are not subject to regulatory oversight.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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