Interactive Investor

Stockwatch: the very real threat of a ‘balance sheet recession’

20th June 2023 10:26

Edmond Jackson from interactive investor

As borrowing costs rise, more of us might pay off debt rather than spend, putting the economy in trouble. Analyst Edmond Jackson studies the theory and possible opportunities.

This week’s major concern – how rising UK mortgages will in due course bite into consumer spending – tallies to an extent with talk about a possible “balance sheet recession” taking shape in China. 

Unpacking the concept, it is an aspect of behavioural economics that refers to when citizens prioritise debt reduction over spending, as do companies instead of maximising profit. Thus a “balance sheet recession” where people are forced to save more and companies invest less, which causes economic slowdown. 

Most typically, it happens after an asset bubble bursts yet people/firms are stuck with debt linked to historically over-priced assets that still need servicing.  

So yes, there is uncomfortable relevance today, as people face rising mortgage rates after a decade or so of house prices rising way beyond their traditional valuation ratio as a multiple of incomes. 

This recent data visualisation by interactive investor demonstrates just how unaffordable housing in the UK has become. You can read the accompany article here.

Source: interactive investor. 

Japan’s three decades of stagnation 

The term was introduced by Richard Koo, a Taiwanese-American economist living in Japan, who became head of research for Nomura. He majored on deciphering perhaps the biggest-ever balance sheet recession, when Japan took over 30 years to recover from its late 1980s property crash.  

There was an equal and opposite reaction to excess debt: “cashmanagemento” gripped the Japanese mindset – never borrow, always operate within your cash flow – which led to its corporate sector having the cleanest balance sheets on the planet, albeit seriously lacking economic demand. 

Koo cites how the US government kept interest on debt as tax-deductible, from the Great Depression until 1985, as evidence of how responses to trauma can have long-lasting effects.  

Relevant to economic risks facing China today 

Various factors have scope to conflate, for China to suffer a balance sheet recession – even if it is not in one yet. 

A key point has been a “zero tolerance” policy towards Covid by the Chinese Communist Party (CCP) – abandoned only last December. 

Companies enjoyed support but households barely any, leaving people traumatised and focused on conserving what finances they had. 

This is in context already of high debt within the Chinese economy, creating a headwind as ever-greater amounts of debt are required to generate future growth. 

There is also the legacy of China’s one-child policy from 1979 to 2015, which implies a significant population decline in decades ahead that is liable to affect economic demand and activity.  

So there are parallels between China today and Japan in the late 1980s: financial imbalances, and leverage and demographic profiles, although China is at a much earlier stage of development, with materially lower GDP per head than Japan back then. 

The CCP’s extent of control means that, for example, guidance and restrictions tend to prevent major house price falls at the cost of fewer sales.  

Yet its recent actions have been timid: a 0.1% cut in the central bank’s short-term interest rate to 1.9% and extending tax incentives for electric vehicle purchases to boost industrial production. Easing home-purchase restrictions in less prosperous cities have not achieved much. 

With public debt at around 300% of GDP, Beijing really has no room for speculative infrastructure projects. In any case, US analysts reckon strains in the Chinese real estate sector could already drag on the economy for years to come. 

I would still beware pessimism. Over years, we have heard serial draconian stories about China: do you recall documentaries on “ghost city” developments, to which shadow banks were exposed? They were meant to portend a financial crisis, but it has yet to happen. US short-seller Jim Chanos spent a good few years talking down China, but he no longer does so, hence must have retreated to lick his financial wounds.  

UK squeeze on mortgage costs to last until 2025 

I do not see it as necessary to predict a full-on, balance sheet recession. The concept informs us of potential risks where a situation of rising asset prices and ultra-low interest rates is over-turned. 

A growing consensus reckons rates are unlikely to fall before the end of next year; it taking nine months for the effects of higher rates to feed through to people’s pockets. 

Further out – and an aspect of “balance sheet recession” – is the rising trend for 35-year-plus mortgage deals. These may stretch well past working age, tempting some people to raid their pension pots to pay off the balance, thereby reducing spending in retirement. 

Tenants are also facing their highest squeeze in a decade, with 28% of pre-tax income going to pay rent. 

Without being a doomster, I think it pertinent to be aware how the UK’s altering situation has some parallels with China’s – by way of propensity to change consumer behaviour – against which, Japan from the early 1990s to mid-2010s, shows a worst-case scenario. 

Yes, the IMF has upgraded its view of the UK economy, not now to anticipate a recession. But I would treat all such forecasts warily. The Bank of England has messed up on inflation management, keeping monetary policy too loose too long. We do not know where interest/mortgage rates may peak, then stay high, and what extent of change there will be to the consumer psyche. 

Meanwhile, the US is tricky to interpret, with mixed signals on consumer confidence, and reporting by consumer-driven companies. The consensus on Wall Street expects a recession, with equities yet to price in how long it will take to bring inflation down. Frankly, only time will tell. 

All 20 eurozone countries are now in recession  

This appears to have got very little coverage, and has happened even before higher interest rates work through to reduce demand. 

Admittedly, it is at the very edge of defining recessions: eurozone GDP falling 0.1% in the first quarter of 2023 against the final quarter of 2022, when GDP also slipped by 0.1% (revised from a previous reading of zero).  

Or, you could say it is most definitely recession, adjusting for inflation. 

A dilemma is governments and central banks having no fiscal and monetary stimulus policy left after over-extending during Covid, such than we now struggle with inflation. 

Upside of more UK takeover situations 

If this tempts you to hide under a rock, notice how today there is an agreed £465 million offer for Lookers (LSE:LOOK) vehicle dealership by the private Canadian company Alpha Auto Group. 

A price of 120p per share represents a 50% premium to the market price a few weeks ago, albeit down on the 170p highs in 2007 and 2015. 

Despite gloom around UK equities (as shown by BT Group (LSE:BT.A)’s £39 billion pension fund having only 0.3% exposure to UK shares) the fact we are projected to remain the world’s sixth-largest economy out to 2050 means UK companies are a target for overseas buyers. 

I would therefore be aware how “balance sheet recession” risks can make economic life more awkward. Yet dark clouds also bear a silver lining - equity special situations will evolve. 

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