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Bad bets and hazards already in the market could trigger the next recession

Friday’s U.S. gross domestic product number was the best in four years, and it follows a long line of economic indicators from jobs to trade to manufacturing that have continued to show strength.

But some economists and Wall Street strategists say there are a number of worrying developments that threaten to undercut the economy. These analysts warn there’s a glut of bad bets and hazardous risk that’s been growing beneath the surface of this strong market that could send the country into a woeful recession.

Watch credit spreads

That things are good now means nothing, says Josh Brown, a financial advisor and the chief executive of Ritholtz Wealth Management.

“Durable goods or consumer confidence or whatever metric, no metric tells you what will happen tomorrow,” Brown told Yahoo Finance in a phone interview. “If it did, reliably, if there were any meaning in any of that, then everyone would be a billionaire because we would all know.”

While the economy looks strong, there are a number of developments that have analysts and economists worried.

Brown says that he’s not necessarily bearish on the market, but is crafting portfolios for clients that aren’t fully exposed to stocks and will shed risk if the market turns. The metric he’s watching is the movement in credit spreads — the difference between the yield on bonds issued by corporations and an equivalent bond issued by the U.S. government.

The latest Moody’s data shows the spread between Baa-rated bonds and comparable U.S. Treasuries this month hit 2%, a level reached either during or just before six of the past seven U.S. recessions since 1970. In February, those spreads were at their lowest since the financial crisis.

‘We’re looking for waves and ignoring the tide’

The bond market is flashing a number of other recession warnings, analysts and economists say.

Most prominent is the steadily declining U.S. Treasury yield curve, which is pointing toward an inversion — meaning 2-year U.S. government bonds pay bondholders more than 10-year issues. An inverted yield curve has preceded every U.S. recession since 1955, with a lag time ranging from six months to two years.

The curve has recently dipped to its tightest level since the summer of 2007, and the spread between the 10-year note and 30-year bond has fallen to less than 0.1%.

The U.S. yield curve is one of the most widely followed recession indicators.

Andrew Weiss, founder and chief executive of Weiss Asset Management, who was noted as having had “a substantial impact” on Nobel Prize economist Joseph Stiglitz’s work, says there are currently three major market developments that worry him. 

Weiss argues that many in the market are distracted by headlines from Washington and popular economic metrics. He’s watching the weakening credit quality in loans, with a record $247 trillion of debt having been issued globally, as well as increased regulation of banks and the worsening demographics of developed economies.

“We’re looking for waves and ignoring the tide,” Weiss told Yahoo Finance.

Particularly onerous to Weiss are so-called covenant-lite loans — those that provide less protection for lenders and investors than traditional loans — which now account for a record 75% of outstanding U.S leveraged loans, according to ratings agency S&P Global’s LCD tracking system. Moody’s reported that 80% of leveraged loans issued in the first quarter were “covenant-lite.”

Weiss said he’s worried about the growth of covenant-lite style loans in Europe, where the issuance of such loans has picked up dramatically in recent years.

The banks also are taking on less of the loans and less risk overall, Weiss said, as a result of government regulation. While it makes the banks look healthier, they’re passing many risky bets on to investors through securities sold to asset managers and private equity firms.

The next recession will be ‘sharper and deeper’

The combination means that much of the debt issued today is less secure and more likely to cause a substantially worse crash if the market and economy head south. That will be exacerbated by a population that is growing older and will require more resources, like Medicare and Social Security, with declining tax receipts and worker productivity to provide it.

“In bad times things can get really bad,” Weiss added.

Similarly, Brian Singer, head of asset manager William Blair’s Dynamic Allocation Strategies Team, laid out four market risks “keeping [him] up at night”: monetary policy, smart-beta ETFs, the Volcker Rule and circuit breakers.

The U.S. gross domestic product output gap is inching toward a focal point.

As the Federal Reserve withdraws liquidity from the market by continuing to raise U.S. overnight interest rates as it has since December 2015, Singer worries that the high correlation of stocks in many of the world’s most popular exchange-traded funds combined with banking regulations and circuit breakers that shut down trading when stocks fall too quickly will worsen problems rather than solving them.

“When the next market decline comes, we believe it will be sharper and deeper than investors expect,” Singer said in a note to clients.

Tariffs are the No. 1 concern

There are also the more well-known risks, including the growing trade war between the United States and China that worry forecasters. Tendayi Kapfidze, chief economist at Lending Tree, says he’s starting to become concerned about housing. The most recent and three-month average of new home sales is weak and coupled with poor readings in existing home sales may be signaling a peak in the market, he said.  

However, he says tariffs are the No. 1 risk to the ongoing recovery because they could offset and negate the positive impact of the tax cut passed by U.S. President Donald Trump and Congress.

“If you don’t get the growth, what have you just bought for this big hole you’ve put in the budget? You’ve bought nothing,” he said during an interview in Manhattan. “So now you just have a big deficit problem that you’ve created and you have nothing to show for it on the other side.”

U.S. Housing starts data has recently turned worrisome.

The tariffs are causing businesses uncertainty and leading many business owners to rethink future expenditures, market data shows.

Even a win in the trade war could be disastrous for the United States and the rest of the world. Tom Essaye, a longtime financial analyst and the founder and editor of the Sevens Report, says the risk of China’s economy slowing down is a major risk that investors aren’t giving enough attention.

“It’s not a problem yet,” Essaye told Yahoo Finance, “but it’s very unlikely the global economy can continue to grow if China has an issue.”

Still, he says of the 10 market indicators he watches, only two are blinking red – the fall in building permits, a major housing indicator, and the demand for copper, because of its use in industrial production and electrical equipment.

“There’s nothing on this right now that makes me nervous,” Essaye said. “However, I think we’re seeing some signs that we are starting to approach the end of this economic expansion.”

See also:

Wall Street managers have cost Americans more than $600 billion over the past decade

It’s the end of the world as we know it, and investors feel bullish

The dollar’s status as the world’s funding currency is in question

Why Trump’s trade war hasn’t tanked the market or the economy yet

Dion Rabouin is a global markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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