Tightening credit = Rising defaults
Most U.S. banks have reported Q2 earnings results. Virtually all are tightening lending criteria and raising loan loss provisions in anticipation of an economic slowdown. The Senior Loan Officer Survey due out on July 31 will undoubtedly confirm these conditions.
U.S. household finances are increasingly stressed. While surplus cash levels are elevated in many industrialized countries in the post-pandemic era, Americans have mostly depleted their savings.
On the corporate side, commercial and industrial loan growth has been abysmal in 2023. In addition, the FT reported that the $1.4-trillion risky corporate loan market has been hit by $136 billion in downgrades, which has only been exceeded by the pandemic shock of 2020.
Don’t worry, be happy
So far, the market is reacting to these potential sources of stress by whistling the song, “Don’t Worry, Be Happy”. Credit markets don’t look very worried. Yield spreads are narrowing and not showing signs of anxiety.
Over in the stock market, financial stocks are turning up against the S&P 500. Relative breadth indicators are also showing signs of improvement (bottom two panels).
From a global perspective, the only signs of financial stress are appearing in China. U.S. large-cap financials are bottoming relative to the S&P 500, and so are the troubled regional banks. European financials are even in better shape as they have been in a relative uptrend that began in March. The only blemish is China, which is dealing with its real estate problems. Since virtually all of the loans are made in RMB, problems in China are likely to stay in China and global contagion risk is relatively low.
Sound the All-Clear?
With the exception of a warning from the elevated level of the MOVE Index, market signals are unabashed bullish. Does that mean it’s time to sound the all-clear?
There can be little denying that, almost across the board, the readings on economic activity have been stronger than our expectations in September… All told, third-quarter growth in consumption looks stronger than we had expected, and spending appears to be headed into the fourth quarter with a bit more momentum.At present, it is difficult to find evidence in high-frequency indicators that the economy is in the process of turning down.
The only warning came from the Senior Loan Officers Opinion Survey as an indication of credit conditions:
In terms of credit provision, the Senior Loan Officer Opinion Survey revealed a sharp jump in the fraction of banks reporting tighter terms and standards on loans to businesses and households, a development consistent with the restraint on spending that we have built into our forecast. Consumer sentiment remains depressed relative to overall economic conditions, perhaps because of worries about financial developments.
How much weight should investors put on today’s shift in opinion by the Fed’s staff forecast from mild recession to soft landing and the downward revisions of Wall Street strategists of recession risk?
What about the message of the market? Technical analysts tell us that price reigns supreme and it’s the best forecast of the future. Let’s consider how the markets behaved in the Mother of Credit Events, the GFC.
Lehman Brothers went on to fail in September and the roof caved in on stock prices. The S&P 500 made an initial bottom in November, rallied and made a final bottom in March 2008.
Here is a more recent example of how technical analysis was unable to discount the risk of a well-known and well-telegraphed event, the start of the Russo-Ukraine War.
Everything changed on February 24, 2022, when Russia invaded Ukraine. The war sent the price of European gas soaring and the margins of BASF collapsed because of soaring natural gas prices.
Possible choppiness ahead
Where does that leave us? For the final word, I refer to the work of New Deal democrat, who uses a methodology of coincident, short-leading and long-leading indicators to forecast the economy. This discipline is especially attractive as it shows a picture that potential growth can evolve over different time frames. His latest update is calling for a mild recession:
- The U.S. economy is showing signs of a slowdown turning into a shallow recession, with weak consumer spending and negative long-leading indicators.
- But short-leading indicators have improved, driven by stock prices and a weak U.S. dollar, suggesting the slowdown may be temporary.
- One scenario suggested by the order of the indicators is an economy that wobbles back and forth between data that shows slow growth versus shallow contraction.
The last point about the wobble between the soft landing and recession narrative is important. If we are in such an environment, investors should be prepared for possible choppiness and the risk of a credit event that could derail the bullish narrative. In addition, investors should be aware of the possible risks from further ruptures in the Sino-American relationship as anti-Chinese rhetoric heats up ahead of the 2024 election (see How the G7 meeting exposes the risks for 2024).