Financial Fragility Gray Rhinos of 2024

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Early in my career I focused on sovereign debt crisis and restructuring, and never lost the bug. So when I think about financial fragilities, debt dynamics are at the top of the list.

In fact, gray rhino theory emerged from my work on the Argentine (2000-01) and Greek (2010-12) debt crises and the question of why only Greece achieved a relatively orderly restructuring. Greece’s recent return to investment grade reinforces the important of swift and strategic responses when financial crisis looms.

As observers continue fret about inflation and economic growth, it’s important to remember that how policy makers, banks, and businesses respond to financial fragilities involving debt will make a big difference to how events unfold.

A crash of debt gray rhinos lurks in many forms: US government debt, US private sector debt including commercial real estate and consumer debts, and emerging markets debt. With US stock markets hitting new highs and residential real estate prices continuing to price out lower-income buyers, there’s also a distinct danger of popping asset bubbles which will make for very unhappy voters.

Monetary policy moves in cycles, which bring big changes with every loosening and tightening. As 2024 unfolds, we will see greater effects of the changes put into motion since the easing of the Covid-19 pandemic in 2022 as governments and central banks began to unwind the extraordinary emergency measures put in place to support the economy during the worst of the historic public health crisis.

How long will pandemic government-spending-fueled growth last? Just because the inevitable economic downturn did not happen in 2023 does not mean that it will not occur at all.

The US and global economies have been cushioned by excess savings built up during the pandemic (but now dwindling and expected to run out by mid 2024), smart debt management by companies that borrowed during the pandemic at lower rates for longer terms (but which will come to a head in 2025), and government spending supporting economic growth. But those supports will not go on forever.

US Government Debt

“Even the United States is not immune to the laws of gravity,” Rob Fauber, President and CEO of the credit rating agency Moody’s Investors Service, told the Council on Foreign Relations in an on-the-record meeting earlier this week.

Moody’s —the only one of the three big US ratings agencies that still gives America its highest rating— downgraded the outlook for US government debt to negative in November 2023 based on concerns including rising interest rates on federal debt affecting debt affordability, combined with continued political polarization.

This came not long after another ratings agency, Fitch, knocked the long-term rating on US debt from AAA to AA in August. Fitch cited the lack of a plan to address medium term fiscal challenges, the likelihood of recession and its impact on tax revenues, and the steady deterioration of governance over two decades. (Translation: It is not a good look for creditworthiness when senior elected officials repeatedly threaten to allow the country to default for political reasons, and the US comes within days of doing the formerly unthinkable.)

The outlook for US debt will depend on politicians in Washington, DC, working together. In an election year, that is a big challenge. Depending on the outcome of the November Presidential election, it could become more or less contentious.

In the meantime, lower credit ratings and outlooks imply higher US government borrowing costs and lower prices for government debt that banks hold as reserves.

Banking Domino Effect

We’ve already seen the consequences of steep drops in the prices of US Treasury bonds as the result of the US Federal Reserve raising rates throughout 2022. Combined with a drop in venture capital funding and businesses drawing down cash, the fall in asset values packed a wallop on the balance sheets of banks big enough to cause a serious scare.

The one-year anniversary is approaching of the failure of Silicon Valley Bank , which in turn set off a brief but serious domino effect hurting two other US banks and then Credit Suisse in Europe.

US authorities quickly announced measures to restore confidence that government deposit insurance would cover amounts above the previous $250,000 limit. Many investors convinced themselves that the bank troubles were more-or-less isolated instances of poor management in general (and risk and balance sheet management in particular) and of troubles in the still-young cryptocurrency world.

But debate continues over what longer-term policy changes would hit the right balance between discouraging moral hazard and irresponsible management and protecting depositors, versus encouraging appropriate levels of risk in order to maximize healthy economic growth. Banks and regulators continue to discuss proposed new Basel regulations to this end.

Expect changes to the rules of the road.

Commercial Real Estate

Rising interest rates and changing economic trends pose another challenge to regional banks’ financial health in the form of commercial real estate, which makes up a significant portion of their lending portfolios. As a result, significant defaults are a major threat to bank finances and lending capacity.

The National Review referred to commercial real estate as a gray rhino in April 2023 and again in August , citing low occupancy rates because of work-from-home dynamics and nearly two-thirds of leases expiring between 2024 and 2029.

There have been several high-profile sales of large buildings at steep discounts to their previous values, as well as developers and investors simply defaulting and walking away.

The research firm Capital Economics has estimated that CRE portfolios lost close to $600 billion in value in 2023, will lose around $500 billion in 2024, and more than $100 billion more in 2025. That makes for roughly a 40 percent drop in value from recent highs.

So where are the opportunities? The situation works to the advantage of businesses looking to secure downtown and other office space cheap. Urban planners and municipal authorities also are hoping to revitalize downtowns by converting under-used buildings to mixed-use spaces

This trend already is beginning. Office-to-apartment conversions in major cities nearly doubled in 2023 , to 45,200 from 23,100 in 2022. RentCafe projects that they will rise to 55,300 in 2024.

These new configurations also could yield climate benefits by reducing the carbon intensity of commutes and of living spaces, since multi-unit buildings tend to be more energy efficient than single-family homes.

Even so, it could take a decade or more before prices return to earlier levels. How soon that happens depends on how quickly defaulted debts are restructured and buildings are reconfigured.

Knock-on Political Effects

How quickly businesses, governments, and economies respond to the changing monetary cycle will have much bigger effects in setting the course for future economic and other policies.

Various economic scenarios will have distinct political implications, particularly in the United States, with a crucial Presidential election coming up in November.?

A strong economy and stock market generally favor the incumbent, while economic troubles generally presage a political change in power. Thus, the timing of the inevitable slowdown, stabilization of inflation, eventual re-easing of monetary policy, and jobs and profits outlooks will have an outsized impact on what coming years will look like.

How should, can, and will policy makers respond? What will businesses do to prepare themselves for major changes to come? How well will they manage liquidity risk as well as credit risk. How well positioned will investors be to quickly jump on the opportunities that an economy changing directions will present?

Stay tuned for more on possible scenarios as well as a holistic set of indicators to keep an eye on.

While I’ve focused mainly on the United States here, it’s worth a reminder that more than 50 countries will hold elections in 2024 with nearly four billion people and half of the world's population making crucial choices for the future. I’ll be addressing some of these in coming weeks. I’ll also be looking in greater detail at emerging markets economies and debt outlooks.

Economic trends also create a strong feedback loop with global trade policies, rules, and growth. A weaker economy could lead to more protectionism, which in turn could inflame already uncomfortable geopolitical tensions.

Which brings us to next week’s theme: geopolitical tensions and their relationship to domestic dynamics, especially in the United States.

This is the third in a series of posts about the obvious, probable “gray rhino” risks of 2024.

Last week: An overview of gray rhino risks and responses for 2024.

Next week: Geopolitical tensions