[LONDON] A former vice-chair of the US Federal Reserve has said that the odds of a moderate recession in the US are higher than what the markets are pricing in.

Richard Clarida, who is now a global economic adviser to investment management firm Pimco, said at a recent media event in London that a major risk to US markets could be a government shutdown because the tax receipts are not matching the high spending by President Joe Biden’s administration.

And with Republicans wary of raising government debt to meet spending needs, another stand-off in Congress could happen when the issue comes up for debate.

“If interest rates do move up, I don’t think it’s going to be because of the Fed. It’s going to be because of the fiscal dysfunction in Washington. Even though the Fed is very powerful, it’s not the only driver of rates; fiscal policy is also a factor,” said Clarida, who worked at the Fed from 2018 to 2022.

“If you just look at simple measures like the amount of government debt relative to GDP in most countries, 20 years ago that number was less than 50 per cent. It’s now around or north of 100 per cent, including in the US,” he said.

Pimco is a US-based company that manages US$1.79 trillion in assets. Its group chief investment officer Daniel Ivascyn said the stronger economic data coming out from the US in recent weeks has led the markets to ease their expectations for interest-rate cuts from the Fed over the next 12 months.

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Ivascyn said Pimco is the most interested it has been in interest rate exposure in many years, and it has also been adding to its position in inflation-linked bonds.

Speaking at the same event, Andrew Balls, Pimco’s chief investment officer for fixed global income, said an unexpected surge in company defaults is a serious “black swan” risk for global financial markets.

He shared the scale of estimates of private lending to those with excessive debt leverage. Private equity, hedge funds and other asset managers have raised credit to corporations from US$235 billion in 2008, during the last global financial crisis (GFC), to US$1.5 trillion currently, said Balls.

This is over and above the bank loans and high yield debt of US and European banks that currently amount to US$3.1 trillion, said Balls, who oversees the European and Asia-Pacific emerging markets and global specialist investment teams.

Collateral loan obligations account for 69 per cent of these private credits, according to Pimco’s data. These securities were a major cause of the GFC in 2008 and 2009.

Brendan Brown, an economist and fund manager in the City of London, noted that Pimco’s private credit estimates cover mainly small and medium-sized enterprises (SMEs).

Pimco estimates that the SMEs’ leverage – debt levels as a proportion of their balance sheet – exceeds that of large companies. On average, the leverage of US middle-market companies is as high as 5.4 times their earnings before interest, taxes, depreciation, and amortisation.

In good times, leverage boosts overall profits as returns exceed interest payments. But as interest rates have soared around the world and business is slowing down, Brown expressed concern that leverage could cause losses and eventual bankruptcies. Investors are also at risk, he added.

Economists note that the huge increase in private loans took place between 2009 and 2021, when interest rates were negligible. Pension funds and other investors who sought higher returns poured money into private equity instead. They, in turn, invested the funds in businesses and loaned them money.

Brown said there are anecdotal reports that some investors are looking to withdraw funds from private equity and other funds.

Well aware of these market uncertainties, as well as the ongoing concerns over the Ukraine war and a slowdown in the China, Middle East and European economies, Pimco’s executives believe that investors should play it safe.

They recommend that investors allocate more of their capital in short-term sovereign and parastatal bonds of two to five years in duration. They explained that these investments, which typically provide annual returns of 4 per cent to 5 per cent, are a hedge against an economic downturn and persistent inflation that could keep interest rates high. 

Medium- and longer-term quality bonds with a duration of 10 to 20 years could experience capital appreciation if interest rates fall, said Ivascyn. Even so, he warned that these are risky because their yields could rise and prices fall if inflation does not decline.