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- Goldman Sachs has flagged five “pockets of risk” that could spark a recession.
- They are the markets for investment-grade bonds, leveraged loans, subprime auto loans, student loans and commercial real estate.
- Goldman says they deserve “active monitoring” even though the risk they cause a full downturn is “fairly low.”
According to Lotfi Karoui, the five markets to watch are: investment-grade bonds, leveraged loans, subprime auto loans, student loans, and commercial real estate. He called for them to be actively monitored, even though “the risk that they drag the broader economy into a full downturn is still fairly low in our view.”
Karoui’s comments follow a recent Goldman report that said financial risk – defined as financial imbalances and the potential for asset-price crashes – was the main driver of recent recessions. As such, he says it represents “an important threat.”
Here’s what Karoui had to say about each of the five recessionary drivers he highlighted on the podcast:
1) Investment-grade bonds
Karoui specifically highlighted the sharp increase in the proportion of investment-grade bonds with a BBB rating – the lowest rating still considered investment grade – from 30% about a decade ago to 50% today.
“The risk is that you wake up tomorrow and there’s a wave of downgrades from … investment grade into high yield [bonds],” he said.
That would create financing issues for businesses, particularly those with large debts that would struggle to deleverage, such as food and beverage companies, he added.
A swathe of downgrades could also cause “technical indigestion” for the high-yield market if it failed to stomach a sudden flood of debt, Karoui said. However, he thinks mass downgrades are unlikely to happen overnight. He notes that BBB-rated companies have been acting cautiously, mitigating the risk in his view.
2) Leveraged loans
The second of Karoui’s five “pockets of concern” is the $1.1 trillion leveraged loan market, which has grown by more than 10% annually over the past few years. Investors are concerned that “issuer friendliness has become a little excessive,” Karoui said. However, the industry’s debt service coverage ratios are “the highest we’ve seen in 15 years,” he added.
3) Auto loans
The $1.2 trillion US auto market also made Karoui’s list due to a 90-day-plus delinquency rate of 4.5%.
“It’s highly unusual to see an increase in delinquency rates in an economy that’s operating at full employment,” he said. “The uptick in delinquency rates has been entirely concentrated among subprime borrowers.
Karoui blamed it on more lenient underwriting standards for the past eight years for both subprime and deep subprime borrowers. As caveats, he pointed out that the delinquency rate is much higher for credit cards and other forms of consumer credit, and the auto market isn’t as volatile and unpredictable as the housing market.
4) Student loans
Karoui flagged the student loan market, which has ballooned to $1.45 trillion in debt across more than 44 million borrowers, as a fourth pocket. The market doesn’t threaten financial stability as the outstanding loans are held in the “strong hands” of the US government, he said, but mass indebtedness poses challenges for households and future growth.
5) Commercial real estate
Karoui described debates about the health of the commercial real estate market as a “tug of war,” with financial models suggesting prices are too high and valuations are stretched. But he says tighter lending standards offsetting the risk of overheating.
Better underwriting standards, lower loan-to-value ratios and higher debt service coverage ratios than in 2008 and 2009 mean lenders are more able to absorb losses than in recent recessions, he argued.
Ultimately, Karoui concludes that “the private sector is still overall in pretty good shape and the risk that we have a financial overshooting…is still very, very low.” He describes the five pockets as “a collection of sector stories” that are unlikely to combine and cause a recession, but are still worth keeping an eye on.