- Societe Generale’s Albert Edwards warns that a recession is still coming.
- He pointed to the growing number of bankruptcies among small firms amid high rates.
- While big firms have survived high rates, Edwards said a recession would eventually hurt them too.
One common reason that economists and investors cite for why the US economy can avoid a recession is that it isn’t all that sensitive to interest rate increases anymore.
But according to Societe Generale’s Albert Edwards, this notion is misguided, and markets are giving up on the idea of a recession too soon.
The bank’s chief global strategist said in a client note on Wednesday that one of the interest rate sensitivity arguments goes like this: large firms have been able to borrow money on the long end via bond issuance, and have then plugged that money into short-end bonds where yields are higher, allowing them to pocket the difference. In the last 12 months, large companies have grown their profits 5% by doing this, Edwards said.
But the key word in that paragraph is large, he said. Small firms haven’t been able to borrow via bond issuance at the same rate, and aren’t as flush with cash to plug into short-end bonds as bigger firms are.
“The resilience of corporate profits has been a key reason this recession has been delayed – especially as companies in aggregate are now a net beneficiary of higher rates,” Edwards said. “Yet beneath the mega-caps the vast bulk of companies are in big trouble.”
Here are the effective interest rates for a few cohorts of the S&P 1500. The top 150 companies (red line) have barely been impacted by higher rates. But the next 600 firms have seen a more substantial rise, and the bottom 750 firms have seen a huge jump from around 4.5% to 6%.
This increase in rates is starting to show up in bankruptcy numbers, Edwards said. As he pointed out, according to the American Bankruptcy Institute, filings for Chapter 11 bankruptcy were up 71% year-over-year in July.
This comes at a time when banks are becoming less willing to keep struggling firms afloat, Edwards said. The Federal Reserve’s Senior Loan Officer Opinion Survey shows 49% of banks are tightening lending standards for small companies. The same is true for larger companies, but again, they typically have larger cash reserves to rely on.
Why does it matter if these are just smaller firms going under? Well, small businesses account for around two-thirds of job growth historically, Edwards said. If small firms are going under in substantial-enough numbers, it’s likely to tip the economy into recession. And that’s also bad news for earnings for bigger companies, which tend to drive the performance of the S&P 500.
“It seems the lights are going out all over the US smaller-cap corporate sector. They weren’t able to lock into long-term loans at almost zero interest rates and pile it high in the money markets at variable rates,” Edwards said. “Ultimately the pain for US small- and mid-cap companies will trigger the recession most economists are now giving up on, and hey, guess what? I think we’ll soon find out that even the large- and mega-cap stocks might not be immune to the indirect recessionary impact of higher interest rates after all.”
Is a recession really on the way?
The jury is still out on whether we’ll see a recession in the near future. Job gains are still solid, as is consumer spending, and economists project GDP will keep growing.
But some indicators show weakness ahead. The Institute for Supply Management’s Purchasing Managers’ Index shows manufacturing activity is contracting, and the number of consumers that are late on credit card, mortgage, and auto loan payments is starting to tick upward.
According to Brian Rose, the CIO of UBS Americas, there are other clues emerging that consumers are running out of gas. In a client note on Thursday, he said that existing consumer savings is running low, and current spending levels are too high to maintain relative to incomes, meaning consumers could soon turn more conservative.
“This combination of rising spending and flat income caused the savings rate to drop to 3.5%. As shown in the chart, on our estimates, households have used up most of the excess savings built during the pandemic,” Rose said. “In our view, the current savings rate is unsustainably low, and the main downside risk to growth is that the savings rate will suddenly move higher.”
Companies also seem to expect a drop in earnings in the next year. This typically coincides with recessionary periods, according to the chart below from Piper Sandler.
Employment and consumer spending data will tell the story of the US economy in the coming months and years. At the moment, both are sitting pretty. But with a Fed still unsatisfied with where inflation is, it’s probably too early to jump to conclusions on what the economy and stocks do from here.
Read More: Rising Bankruptcies Threaten to Sink S&P 500