- Pimco heeded the advice of Nobel-winning economist Richard Thaler and conducted a so-called premortem to keep its bullish biases in check.
- Although the firm does not expect a recession this year, it identified a corner of the credit market as the probable accelerator of an economic downturn.
- The $1.9 trillion investment firm also shared the investing implications of this risk.
- Click here for more BI Prime stories.
One does not need be bearish on the economy to start thinking about the next recession.
Just ask Pimco, the global investment firm with $1.9 trillion in assets under management.
Its team of US economists put heads together to formulate an outlook for the economy in 2020 — and concluded that there likely will not be a recession this year.
But in the course of their work, they were aware of two realities. The first is that most economists are bad at forecasting the precise timing of recessions. Secondly, the US is in a record-long expansion. And since old age will not cause a recession, it is worth keeping tabs on the vulnerabilities that actually will.
And so despite the economists’ bullish outlook, they decided to investigate and nail down potential triggers for the next recession.
This move was inspired by Richard Thaler, the 2017 winner of the Nobel Memorial Prize in Economic Sciences and a PIMCO advisor. Thaler is a legend in the field of behavioral economics, whose work interrogates and seeks to correct irrational financial decisions.
Thaler advised that PIMCO economists conduct a premortem, which is essentially the opposite of a postmortem. It is intended to rein in the groupthink and overconfidence that comes with adopting a particular viewpoint.
With that in mind, the economists assumed there would be a recession in 2020 and then worked backwards to workshop its most plausible causes. They landed on the $2 trillion private credit market — and its riskiest segments in particular.
3 years in the making
They traced the genesis of this risk back to 2017, when non-bank lending entered an upturn.
Small- and mid-size firms accessed financing they otherwise would not have qualified for. These companies rode the wave of economic growth that swept the world in a synchronized fashion three years ago.
Fast forward to 2019, the economy began to slow. Private lending rolled over with it, and banks tightened their standards on commercial and industrial loans with stricter terms.
As the chart below from PIMCO shows, private lending activity is closely linked to economic growth.
To be sure, the impact of a private-credit crisis on the economy can be offset by the jobs market and consumer spending — both of which are much bigger contributors to growth.
“However, if growth slows further in 2020 rather than picking up during the year as in our baseline, the riskier segments of the credit market would seem vulnerable,” said Joachim Fels, PIMCO’s global economic advisor, in a recent note.
“Private credit, leveraged lending, and high yield debt have been concentrated in businesses that are highly cyclical and have riskier credit profiles.”
To recap: nonbank lending to riskier companies surged in 2017 when the economy was stronger. But it is now slowing along with the economy.
One final observation Fels makes is that speculative grade lending iss currently around 35% of GDP. The implication is that stress in these sectors would be “more than enough to contribute to a recession,” he concluded.
He advised investors in generic corporate credit to take a defensive stance. Additionally, equity investors should overweight large cap stocks over small caps.
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