Recession risk is still out there. Here’s why

The risk of recession appears to be sidelined for now, but investors may be overlooking one factor, argues Pendal’s OLIVER GE

• Tightening credit threatens business viability
• Bonds best protection from recession
• Find out about Pendal fixed interest capabilities

A NUMBER of US banks and analysts have walked back their recession predictions in recent weeks.

But there are still worrying signs in the business sector, cautions Pendal’s Oliver Ge.

Much of the discussion about higher interest rates has focused on the impact of bigger mortgage repayments for homeowners.

But tightener credit conditions and stricter collateral requirements for business are likely to have a more significant impact on the economy, argues Ge, an assistant portfolio manager with Pendal’s income and fixed interest team.

“There’s a growing narrative that the economy can navigate through this tightening cycle without derailing growth and causing havoc to the jobs market.

“It can be hard to argue against this. Despite 400 basis points in hikes from the RBA, economic activity remains reasonably robust and domestic employment is incredibly strong.

“But the economic brakes applied via interest rates is very gradual.

“What often gets overlooked is that there is another transmission mechanism — the tightening of lending standards — that carries perhaps more importance to the business cycle.”

As interest rates lift, banks will increase the perceived credit risk of all borrowers. To mitigate these risks they will impose stricter income and collateral requirements on their borrowers.

Small businesses are generally more reliant on bank loans given that they have fewer alternative sources of funding.

“It’s not the cost but access to credit that matters,” says Ge.

“Small business owners rely on a flow of working capital to pay their suppliers and employees. At the moment, the banks are happy to supply that. But should lenders’ outlook on the economy turn, they may have to cut off those lines of credit”.

 “That’s when businesses will be forced to pare back on labour and supplies. That spills over into the rest of the ecosystem — that’s when you get that pain.

Tighter lending in the US

As you can see below, there’s evidence that banks are already tightening lending in the US, where the Federal Reserve conducts a quarterly survey of the biggest banks to assess lending terms.

“Lending standards have tightened significantly, comparable to historic highs,” says Ge.

“Business cash buffers are running out and you’ll likely see a wave of defaults over the course of the next six-to-nine months.

“Ultimately, that is where we’re headed. But it’s not something people are factoring into their forecasts.”

A tightening of lending standards has real potential to push the global economy into recession, says Ge.

“Whatever happens in the US will filter through to the rest of the world. There’s no way that Australians can somehow insulate themselves.

“At the start of the year, people were tossing up between a soft and hard landing. The hard landing scenario has faded from people’s memories.

“But the prospect of recession is still very much out there.”

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About Oliver Ge and Pendal’s Income and Fixed Interest boutique

Oliver Ge is an assistant portfolio manager with Pendal’s Income and Fixed Interest (IFI) team.

Oliver works on developing and running key quantitative investment models, and acting as trading support for the team. Oliver received his Bachelor of Commerce (Finance) from the University of Sydney and is also a CFA Charterholder.

Pendal’s IFI boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

The invests across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

About Pendal Group

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

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