Be Cautious, Be Humble, Be Prepared!
When the short-term and long-term debt cycle collide
In my last article The Effects of Low Interest Rates I showed how the extremely low interest rates in the last 15 years contributed to the situation we are in right now. And while it is easy to describe what happened in the past (and due to hindsight bias we often assume that we already knew before what would have happened although that almost never is the case) the much more interesting and more difficult to answer question is: What will happen next?
Going Higher And Higher?
One of the lessons learned from the past is the fact that trends usually continue longer than most are anticipating. And hence we can ask the question why we can be certain that the global economy is heading for a severe recession or even depression. To be very clear here: we can’t know – nobody does know what will happen. And it certainly is possible that asset prices (stocks or real estate) will continue to go higher in the next few months, next few quarters, or even next few years.
Cycles Are Ending
Knowing beforehand when the top will be in, is close to being impossible (also there are ways to set targets in the chart by using Elliott Wave Theory for example). And of course, there are hints. Ray Dalio for example is writing:
When things are so good that they can't get better - yet everyone believes that they will get better - tops of markets are being made.1
And while we can never know for sure, we can identify patterns and see similarities to the past and in my opinion, we are very close to the end of several cycles. We are close to the end of a short-term debt cycle (also called business cycle), but we are also close to the end of the long-term debt cycle. And although it is not really a cycle, the political internal and external order is rather switching towards disorder. In the following sections we are looking at two cycles in more detail – the short-term debt cycle and the long-term debt cycle – to understand why the probabilities for another recession or depression are rather high at this point.
Short-term Debt Cycle
Short-term debt cycles are usually taking between 5 and 10 years and when looking at the last few decades, we have the data for several recessions making it easier to see patterns. Additionally, the short-term debt cycle seems more familiar to most investors making it more likely that people are accepting this kind of cyclicality (expecting the long-term debt cycle to come to an end seems less unlikely for most people as we never experienced such a case in our lifetime or if you were already alive you probably don’t have many memories about that time).
There are several hints when the expansion phase of a short-term debt cycle is coming to an end. Ray Dalio is writing in Economic Principles:
In this phase, actual or anticipated acceleration of inflation prompts the Fed to turn restrictive, which shows up in reduced liquidity, interest rates rising and the yield curve flattening or inverting. This, in turn, causes money supply and credit growth to fall and the stock market to decline before the economy turns down.
And in the last three years we already saw the accelerated inflation (reaching numbers we haven’t seen for several decades) followed by the FED tightening with a pace also not seen in decades.
When looking at the data we clearly see inflation increasing and as a reaction the FED increasing interest rates – and we also see a similar pattern before every recession.
Additionally, we saw the yield curve inversion (which has happened before every recession and is one of the best early warnings indicator for a recession).
One of the next steps that is usually happening – and which is also mentioned in the linked article above – is the rising unemployment when heading into a recession. While there are different metrics measuring different facets of unemployment, the initial unemployment claims are probably one of the best metrics we can use as early warning indicator. When looking at the 4-week moving average, we don’t see increasing numbers so far. To be more accurate, we are at the lowest number ever reported (about 200,000 people initially claiming unemployment insurance weekly).
Aside from rising initial claims for unemployment insurance, the FED pivot is one of the next steps to look out for. At this point it seems quite obvious that the FED won’t raise its rates further, but before the FED did not cut rates, we can’t call it a FED pivot (as further rate increases are also possible). When looking at the federal funds rate chart above, it is also not untypical that the interest rates are stable for several quarters before the FED is cutting rates again. So far, the federal funds rate is stable for about six months and almost everybody seems to expect rate cuts in 2024 – it is just unclear how many cuts and how steep (see here and here for further information).
And when moving away from the FED and interest rates (as well as metrics that are connected to interest rates – like inflation or the yield curve), we can look at some other metrics which could be early warning indicators. This is including the United States ISM Service PMI (purchasing manager index). When this metric is falling below 50, it is a good indicator for an upcoming recession. And the metric is falling since late 2021 and with the last reported number being 50.6 it is very close to indicating a recession. And I use the service PMI instead of the manufacturing PMI as it is the much more reliable indicator for recessions.
Aside from the purchasing manager index, we can also look at construction metrics. And like purchasing managers are ordering products for a business at the beginning of the value chain, one of the first steps in construction is the granting of housing permits (if necessary). And when looking at housing permits, we see a steep decline in 2022, but in 2023 the number held up quite well.
Summing up, I think we are at the very end of a short-term business cycle. And although I expect the United States to hit a recession already in 2023 (based on the typical stretch between the yield curve inverting and the beginning of a recession), the outlook remains the same despite the timing being a little off.
Long-term Debt Cycle
A long-term debt cycle can take up to 100 years until it is completed – and to time the top in such a cycle is more difficult than for a short-term cycle. While we can be pretty sure that we are at the end of such a long-term cycle, we might be easily off by a few years (and in my case that is also the case as I have been expecting the cycle to end for several years now and have been wrong). But the economy being close to the end of a short-term cycle (and the bursting of a bubble) makes it likely that the long-term debt cycle could also end now.
Similar to early warning indicators for a recession, there are also signs for a depression and the end of a long-term debt cycle. For starters, one of the signs for being at the end of a long-term debt cycle is the occurrence of bubbles, which is best measured by prices being extremely high relative to traditional measures. The CAPE ratios in the last few years – especially in 2021 – were in no way justified. And although the ratio is a little lower (31.5), we are still at levels only seen twice in the last 150 years (around 1929 and around 2000).
Dalio is also writing:
In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap in ration to both past earnings and expected earnings, failing to account for the amount of decline in earnings that is likely to result from what's to come.2
And in my opinion, we are seeing a similar pattern now and the fact that many investors will disagree about the unreasonably high CAPE ratio is also a sign for us being rather close to the end of the cycle. Most people don’t see declining asset prices or the economy running into major problems even as a possibility. Although many are expecting a recession – it is often called the most-anticipated recession in history – many people don’t understand the consequences. And at least most investors don’t assume this has an impact on asset prices. In my last article I already wrote:
Additionally, investors also expect continuously increasing asset prices – and that expectation is still alive and well. Especially as many investors can’t even imagine anymore that asset prices might decline – the conviction that the FED will save the stock market again and again seems to be deep-rooted right now.
And early in the top (or bubble busting process) some parts of the economy and credit system are suffering. Although more than 10 months have passed and many seem to have forgotten it already, in March 2023 we witnessed several major bank failures – especially Silicon Valley Bank and Signature Bank collapsed (see here for more details). So far, banks seem to be stable and obviously there is no reason to worry (at least that seems to be the consensus). However, I don’t know if that is true. For example, when looking at the huge unrealized losses the banks currently have on their books, there is enough reason to be cautious. In the third quarter 2023, U.S. banks had about $680 billion in unrealized losses on their books.
Another sign that the financial system is close to a bubble bursting are a lot of new buyers entering the market (here we are especially talking about buyers of financial assets). Depending on what study or poll we use (see here and here) we get slightly different numbers, but the overall picture is the same: the number of shareholders in the United States was the highest for several decades in the years following the pandemic and has constantly been increasing.
In the end, the most important trigger for the long-term debt cycle coming to an end and the bubble bursting are once again interest rates. The reversal in the long-term debt cycle is usually triggered by already extremely high debt levels and elevated asset prices and interest rates suddenly being raised. This leads to lower asset prices and higher debt service payments. And especially these high debt service levels (interest payments) generate major liquidity problems that led to the bubble bursting.
It is usually a cash flow problem and a liquidity problem that causes a recession or depression. And with steeply rising interest rates it often gets more difficult to meet interest payments which can trigger the reversal. And the FED raising interest rates from 0% to about 5% in about 18 months certainly had an impact on the economy.
The low interest rate environment creates larger amounts of debt than can ever be paid back. But as long as interest rates are low it seems acceptable, especially as interest payments are not really worth mentioning. But with rising interest rates the picture suddenly changes and a reversal can be triggered.
Bottom Line
While we can be pretty certain about the short-term (business) cycle coming to an end, it is much more difficult to predict if the long-term debt cycle is also coming to an end (or if it will take a few more years). But we see strong warning signs at this point and being cautious about risky investments (like stocks) is appropriate in my opinion.
Ray Dalio (2018): Principles for navigating big debt crisis. Part 1: The archetypal big debt cycle. Greenleaf Book Group, page 21.
Ray Dalio (2018): Principles for navigating big debt crisis. Part 1: The archetypal big debt cycle. Greenleaf Book Group, page 22f.