US slowdown: A warning for global investors

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Rising bad loans and tighter credit conditions suggest the US corporate credit cycle has turned.

This can become dangerously self-reinforcing. Tighter credit conditions depress growth, which in turn hurts profits and companies' ability to repay their debts.

While we don't see an imminent "sending off" for the US economy, we are issuing a "yellow card" warning that the economy will slow through 2017, and a possible 2018 recession is on our radar.

Consensus growth forecasts assume the US economy will continue to grow at a steady pace through 2017 and 2018.

We share some of this optimism in the near term: our lead indicator framework points to stronger growth through the rest of 2016 as government spending accelerates and the drag from weaker energy capex drops out.

But beyond the next few quarters, we're worried the credit cycle has turned from a virtuous circle to a vicious one.

And like a snowball rolling down a hill, it will become larger over time.

Is the virtuous cycle turning vicious?

Stronger growth boosts profits. This helps companies service their loans. And a decline in delinquencies, loans greater than 30 days overdue, makes banks more confident about making new loans, boosting growth.

We worry this virtuous cycle is turning vicious in the US. The crisis in emerging economies and the collapse in domestic oil investment have hurt economic growth.

This, combined with a stronger dollar and a tight labour market, has pushed profits lower.

Moreover, the Fed has also started to raise interest rates and so we've seen corporate delinquencies jump.

To cap it all, banks are reporting they're tightening credit conditions for corporate clients. We worry this can become self-reinforcing.

The benign view is the bad loans are concentrated in the oil exploration sector--so as long as the rest of the economy holds up, delinquency rates will fall back after these oil companies go bust.

The problem with this analysis is banks do not hold equity in winners. Instead, they only make loans to winners and therefore get the same interest payment from them regardless of their profitability.

Consider, for example, a two-sector economy consisting of oil explorers and airlines.

A halving of the oil price would cause bumper profits for the airline sector as their biggest cost—fuel--collapses. Yet for oil explorers, the difference between $100 and $50 oil could be one of survival versus bankruptcy.

How does this affect the bank?

It gets the same fixed 5 per cent interest payment from the airline, no matter what the oil price is.

But a low oil price causes the oil explorer to become bankrupt and the bank makes a big loss on that loan.

Corporate delinquencies: tighter credit conditions

As the bank licks its wounds, it becomes more cautious about making further loans. This explains why changes in corporate delinquencies tend to lead changes in credit conditions.

So, the recent jump in both US corporate delinquencies and tightening credit conditions is worrying as we could be heading into a downward spiral.

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We don't think the US economy is about to get "sent off" with a straight red card. The recovery started in 2009 and our credit framework suggests a recession is plausible in 2018, so we're in year seven out of nine.

Perhaps the manager will make the right substitution and we'll score an equaliser and get extra time. But you've been warned: Yellow card.

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