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The ghost of 1938


Patrick Kelliher

Since the financial crisis of 2007/09, economic growth in the UK and the rest of the EU has been patchy but the US has generally been posting steady if unspectacular growth figures. Were it not for dips in Q1 2011 and Q1 2014, it would be entering its 26th quarter of real growth since the trough of the downturn in Q2 2009 to the end or 2015 [1]. This is on a par with the expansion in the US economy in the run-up to the financial crisis, which begs the question: how long can this growth last ? and what would be the impact when the recovery falters ?

An uncomfortable precedent if it falters is the US recession of 1937/38. As at present, the US was recovering from a balance sheet driven recession, though the depression of 1929/33 was much worse the financial criis of 2007/09, with GDP falling 45% in nominal terms between 1929 and 1933. After that fall, GDP recovered strongly, growing by 63% in nominal terms between 1933 and 1937, partly on the back of President Franklin D. Roosevelt’s “New Deal” public spending programmes. While nominal GDP was still lower than in 1929, real GDP was higher.

This growth went into reverse towards the end of 1937, with GDP in 1938 falling 6% in nominal terms. There are many arguments as to what caused the downturn. Keynesians point to fiscal tightening in 1937. Monetarists point to the tightening of Federal Reserve requirements beforehand. Others point to various explanations such as the expansion of the monetary base before 1937; the impact on investor sentiment of a stockmarket fall in 1937; and/or an influx of gold from Europe due to political uncertainty caused by the rise of Hitler [2].

A lot of these factors are present in the US economy today. Reserve ratios have increased due to Basel III while there has been a significant increase in the narrow money base since 2008 due to quantitative easing (QE). Stockmarkets have taken a beating recently with fears over a slowdown in China. Meanwhile concerns over European growth and the political future of the EU have helped push the Euro down against the dollar.

The dollar has also risen on the back of the recent rise in interest rates, from 0.25% to 0.5% p.a., and the expectation of more rate rises to come. While the Fed has been cautious in monetary tightening, there is still the risk that rate rises could prove premature and push the US economy back into recession. In Sweden, the Riksbank increased base rates from 0.25% to 2.0% between June 2010 and July 2011 but then had to reverse this as the Swedish economy went into recession.

There are other factors which could push the US into recession. The current election campaign has thrown up some interesting characters to say the least, and this could introduce political uncertainty into investment decisions. While US consumers have benefitted from low oil prices, these are driven by a Saudi strategy to drive out higher cost producers. Whether the Saudis are successful, or have to abandon their strategy due to the havoc this is playing with their finances, it is likely oil prices will rise at some stage, notwithstanding Iranian oil coming on-stream. Even a modest rise could hurt US consumers and tilt the economy towards recession.

The external environment doesn’t look too well either. Europe remains weak, and could be destabilised by any combination of the refugee crisis; Brexit; Grexit; and possibly further bailouts for say Portugal. As noted China is slowing down and this has hammered Chinese stockmarkets, which may depress domestic demand on which China is becoming increasingly reliant. Weak Chinese demand will further hurt commodity exporters like Australia and Brazil. China also faces risks posed by the extensive growth in debt in recent years and related fragilities in its shadow banking system. Then there is the risk of trade disputes between China and the US over the value of the Yuan and/or between China and the EU and others over alleged “dumping” of steel. If these got out of hand they would hurt both the Chinese and the wider global economy.

So there are a lot of risks to the US and the wider global economy. Unlike 2007, governments and central banks are more constrained in how they could respond to any downturn. Most governments have high debt : GDP ratios brought on by deficit spending to address the last downturn, and their scope to run higher deficits is limited. Central banks have cut short-term rates to near 0% limiting monetary stimulus (though they may set negative interest rates).

One possible option open to central banks would be to expand QE. This could drive down long-term government bond yields but this would have an adverse effect on life insurance and pension scheme liability values.

A downturn is likely to lead to further falls in stockmarkets but a key impact of a downturn might be on bond markets. Already low oil prices are leading to defaults in the energy sector but a global downturn could lead to further defaults and downgrades. Looking at the Moodys “Annual Default Study: Corporate Default and Recovery Rates, 1920-2014” (March 2015), the highest default rate for investment grade corporate bonds arose not during 1929/33 but in 1938 with 1.55% of such bonds defaulting. Admittedly the number of defaults was small (9) with more investment grade defaults arising in 1932, but the number of bonds rated investment grade had shrunk, in part because of the damage the depression had caused to companies finances [3]. Notwithstanding economic recovery since 2008, it is possible that many companies have still not recovered from the financial crisis, and that as in 1938, a further downturn could prove fatal.

Further defaults could destabilise bond markets which are showing some signs of distress. High yield (“junk”) bond spreads have increased by ca.200bps, and emerging market spreads by over 100bps, since July 2015. Two junk bond funds have had to suspend redemptions, prompting some comparisons with the suspension of Bear Sterns hedge funds in 2007 which many see as the start of the financial crisis [4].

If defaults and downgrades prompt further bond investors to sell, they might find it difficult to get a buyer. As noted in my previous blog, there has been a sharp drop in bond market liquidity [5], with market maker capacity being cut by 75%. Many might only be sell their holdings at fire sale prices, which would depress valuations for other bonds. Further bond funds may have to suspend redemptions, which could pose operational challenges for fund managers and life insurers, particularly those who might only have experience of suspending property fund redemptions. This could also trigger liquidity crises for insurers and others investing in bond funds.

Bond market turmoil could create an adverse feedback loop for the wider economy. US firms have traditionally been heavily reliant on bond markets for funding but there has been an increase in European firms tapping bond markets, in part because of difficulties in obtaining bank finance. Such firms could face a serious credit crunch if they cannot roll over or raise fresh debt on bond markets, not least because bank lending is likely to continue to be anaemic as banks strive to meet higher Basel III capital requirements. This credit crunch is likely to add to defaults, to lay-offs of workers and to the economic downturn.

To summarise, with Europe and China faltering, a lot depends on the US economy continuing to grow but there is a significant risk that it will stall and fall back into recession, triggering a wider global downturn that governments and central banks will be hard pressed to manage. QE is one of the few tools available to combat such a recession but this will push down risk-free bonds yields further, harming life insurers and pension funds. I would be particularly concerned about the risk of a sharp spike in defaults and downgrades and/or a collapse of the bond market which would lead to large rises in spreads and potentially fund closures and a credit crunch in the wider economy.

[1] US Bureau of Economic Affairs National Economic Accounts – Gross domestic Product (GDP) available at and accessed on 29th January 2016. Note references to nominal GDP growth in this blog relate to GDP in current dollars, whereas references to real growth relate to GPD in 2010 dollars.
[2] See for example  
[3] Annual default study available from Moodys website ( on registration. The rate of 1.55% for investment grade bonds is taken from Exhibit 30 on page 29 while the number of defaults is taken from Exhibit 16 on page 18.
[4] Junk bond and emerging market spread details taken from Babson Capital Management’s “Market Update” dated 26th January 2016.
The junk bond funds which suspended redemptions were Third Avenue which suspended redemptions on December 10th and Stone Lion Capital which announced a suspension of redemptions from its junk bond funds the following day. While Stone Lion Capital was a hedge fund manager, Third Avenue was a mutual fund specialising in distressed debt, which had lost 27% of its value in 2015. This fall and withdrawals had caused its assets to shrink from $3 billion to $790m.
[5] See


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