How to Prepare for the Impending Recessionary Storm
The US economy is a credit-based economy that follows a cyclical pattern called a credit cycle. Typically, a credit cycle is characterized by growth, slowdown, contraction, which is also called recession, and recovery phases. During the last few decades, the span of a credit cycle in the US has ranged from six to nine years.
The last US credit cycle post-2008 recession was unusually long, which was based on a number of factors. Foremost, the great recession of 2008 was quite severe, which meant the recovery phase as the economy emerged from the recession, was longer than normal. The financial sector was the worst impacted during that recession, resulting in an impact that cascaded across the entire economy.
To avoid systemic failure of the financial ecosystem like the one observed in that recession, numerous regulations were introduced with the aim of enhancing the safety and soundness of major global and national financial institutions. One of the key objectives of those regulations was to require banks and financial institutions to have a sufficient capital position that would enable them to withstand severe economic shocks.
Financial institutions went through a large-scale, multi-year transformation to become fully compliant with the new regulations. This, coupled with a conservative outlook by most major banks towards the credit side of their business, slowed the pace of growth in the last cycle.
This credit cycle was also marked by a long growth phase which was fueled by an extended period of unusually low lending rate environment set by the Federal Reserve’s fiscal policy. The COVID-19 pandemic was an aberration that unexpectedly snapped the last US credit cycle. The nationwide lockdown necessitated by the pandemic forced the economy into a recession. The pandemic, as well as its economic repercussions, led to an unprecedented response by the government, which introduced numerous economic relief measures to assist households as well as businesses.
The government-backed relief measures resulted in trillions of dollars being pumped into the economy, creating significant liquidity in the market. They were followed by persistent supply-chain disruptions caused by the lingering pandemic, energy supply volatility caused by sanctions resulting from the war in Europe, and food supply challenges caused by two of the world’s largest grain producers at loggerheads. The confluence of these events has resulted in high inflation since 2021, peaking at a four-decade high of 9.1 percent. This left the US Federal Reserve with no choice but to swiftly raise interest rates in an effort to cool down the economy with the hopes of containing inflation.
Fed’s actions mark the economy entering into a slowdown phase. The most likely outcome of such an attempt to stabilize the economy, as observed during previous credit cycles, is the onset of a recession leading to the contraction of the economy. The nature and severity of the recession will be determined by a variety of factors, including inflationary trends, geopolitical outlook, lending standards and credit quality of outstanding loans, overvaluation of assets creating potential bubbles across different sectors of the economy, and policy measures.
Ignoring the recessionary aberration imposed by the COVID-19 pandemic, the US economy has now entered a phase that mirrors the tail phase of the post-2008 credit cycle. This precursory phase to a recession calls for preparedness on the part of consumers and financial institutions when it comes to credit consumption and extension, respectively.
I had the opportunity to discuss the current macroeconomic outlook and its ramifications for U.S. consumers and businesses with Mr. Sundeep Yerapotina, Chief Risk Officer for Rewards Branded Credit Cards at Citibank. He is a subject matter expert in the field of personal finance, credit strategy and risk management.
“As the economy has started showing signs of deceleration, it is important for households and businesses to brace for a recessionary storm. We will be able to gauge its intensity when it makes landfall,” said Yerapotina. “Consumers need to start shoring up their rainy day funds to be able to withstand disruption to their primary sources of income for up to three to four quarters. As borrowing cost and debt repayment burden rises with increasing interest rates, consumers should try to avoid unsustainable discretionary spending to not accrue debt on credit products with high interest rates. They should also explore options to consolidate debt to proactively manage their repayment burden. Businesses, on the other hand, need to stay cautiously optimistic in the near team. They should account for the risk of a recession in their investment decisions for short-term projects. It is important for businesses to build flexibility in their planning, to be able to reprioritize in the event of a recession.”
“Unlike the 2008 recession, major banks in the US have a strong capital position today. Many of them are maintaining higher capital ratios than the regulatory minimum required and should consider raising them further based on the risk profile and sensitives of their portfolios,” Yerapotina opined. Based on his experience in developing industry-leading risk management solutions for recessionary environments, he added that “banks at some point should tighten their underwriting and credit management standards to prudently balance extension of credit to customers who have the capacity to repay, while limiting it to those who may be vulnerable in a recessionary environment, risking default on their debt repayment commitments.”
Navigating the US economy through this uncertain period calls for measured actions by the Fed, the US government, businesses, financial institutions, and consumers. Avoiding major blows to the economy and post-recession scars such as the ones left by the 2008 recession should be the target. Only time will tell how we fared.
