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The Credit Impulse Weakens

The objectives of this research paper

The research paper will define a relatively new economic term – credit impulse – and explain why it suggests that an economic downturn is around the corner.

The definition of credit impulse

Credit impulse is defined as the change of new credit issued as a % of GDP, and the term was coined by Michael Biggs, an economist at Deutsche Bank, in 2008. In the past, economists mostly focused on the credit stock when trying to estimate credit’s impact on economic growth, but Michael Biggs convinced many that one had to compare flow to flow – not flow to stock.

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Since 2008 it has been shown that, in most countries, private sector demand correlates very closely with credit impulse - both in the business sector and the household sector (see example in chart 1).

Chart 1:  Credit impulse’s impact on final demand in the United States
Chart 1: Credit impulse’s impact on final demand in the United States
Source: www.clearonmoney.com/dw/doku.php?id=public:credit_impulse_background

Credit impulse as it stands around the world

Now to the bad news. Credit impulse is currently weakening in large parts of the world. The euro area first. Credit impulse has led every recent turning point in the economic cycle in the euro area, and it is therefore only reasonable to expect the second quarter to prove the peak of the current economic upturn (chart 2).

Chart 2: The euro area credit impulse has plunged
Chart 2: The euro area credit impulse has plunged
*Shown in USD to allow comparison with impulses in other countries
**Annualised
Source:  BCA Research

Credit impulse in the U.K. peaked a bit earlier than in the euro area – more precisely in late 2014. Despite some recent strengthening, the absolute level is still much lower than the levels we experienced in 2013-14 (chart 3).

Chart 3: U.K. household credit impulse has peaked
Chart 3: U.K. household credit impulse has peaked
*Advanced by 3 months
**Annualised
Source: BCA Research

The story is not dramatically different in the U.S. where credit impulse peaked earlier this year (chart 4).

Chart 4: U.S. credit impulse is fading
Chart 4: U.S. credit impulse is fading
*Advanced by 5 months
**Annualised
Source: BCA Research

Interestingly, China is the only major economy where credit impulse is holding up relatively well. This is particularly remarkable, considering the recent 30% equity correction on the stock exchanges in Shanghai and Shenzhen (chart 5).

Chinese credit impulse does not suggest a massive economic slowdown around the corner in China as many expect. Either investors have created mountains out of molehills or something else is at work.

Chart 5: Chinese credit impulse is near peak levels
Chart 5: Chinese credit impulse is near peak levels
Note: Shown in USD to allow comparison with impulses in other countries
Source: BCA Research

Conclusion

The only conclusion on can arrive at is that an economic downturn in large parts of the world is quite likely – probably later this year. Before anyone accuses me of being a scaremonger, please bear in mind that the cyclical upturn we have been in since the financial crisis is getting very long in the tooth.

There is absolutely no reason to expect a repeat of 2008 which was an extraordinary downturn in many respects. Expect more of a traditional cyclical downturn. I am not even convinced that it will turn into a recession in the traditional sense of the word (i.e. two consecutive quarters with negative GDP growth), but I do expect that GDP growth will (at least) weaken quite materially from recent levels.

This will challenge monetary authorities as they have little room for interest rate cuts to stimulate economic activity. It will also challenge us in our search for low equity beta investment strategies, as the expected return on many strategies will fall – at least temporarily.

Niels C. Jensen

31 July 2015