Fed Chairman Bernanke’s April 2 testimony to Congress specifically noted how capital constraints in the banking system are affecting lending. Supporting this, data from Dealogic, shows high yield debt underwriting fell 48% QoQ in Q1, the volume of equity underwriting fell 58% QoQ, completed M&A fell 45% QoQ while announced M&A dropped 26% QoQ, and investment grade issuance was flat.
I believe this credit crunch will persist longer than the recent rally in US rates, 2s to 1.871% and 10s to 3.575% imply. I looked at the capital position of the 10 largest financial institutions—by risk-weighted assets in the US—which revealed the capital position is weaker going into this US downturn than in 1990 (7.2% in ‘08 vs. 7.5% in '90). This seems logical because lending tends to fall when banks rebuild capital (more on this below).
A counterargument is that the magnitude of Fed stimulus in this cycle implies a rapid end to the credit crunch. However, the credit growth continued to collapse even after Fed rates had become highly stimulative in the early 1990-91 credit-driven recession.
Similarities between now and 1990-91: a) inflation spikes moderately and erodes consumer purchasing power; b) housing and real estate suffer a downturn amid a sick banking sector; c) credit market conditions tighten significantly and d) relatively strong growth abroad persists amid domestic weakness.
However, the current situation is worse than in the 1990s. The US economy is dramatically more leveraged with bank credit alone at 65% of GDP, up from about 47% of GDP in '90. Additionally, housing prices are falling more broadly and more rapidly going into this recession than in '90, increasing the magnitude of write-downs. Bridgewater makes a good case of increasing bank losses in their Daily Observations on April 3rd.
- Banks have barely taken any losses in old-fashioned loans, but these losses are coming. In the past, banking crises tended to lag market crises, because most of the banking system was based on loans that were not marked to market. Loans don’t go sour until the cash flows go bad, while markets go sour in anticipation of problems.
- Loans still make up the vast majority of commercial banks’ balance sheets and major losses. If the loans were marked to market, our numbers suggest write-downs in major commercial banks’ capital of nearly 70 percent.
- Banks won’t be marking to market, but the loan losses will add up quickly and for commercial banks the losses will likely be at least in the range of the recognized security losses (i.e., the losses on the securities were much higher per unit, but the loans make up much more of the balance sheet). ~ April 03, 'The Loan Losses Are Still To Come' Bridgewater Daily Observations.
Equities & FX Biases
Regionally, US equities ought to benefit most from a fall in risk premiums, as the policy response has been most aggressive from the Fed. A weak USD is also a plus for US earnings. EUR strength poses a risk to European growth and margins. Similarly, a strong yen and a lackluster domestic growth are likely to hamper Japanese share price performance (reflected in equity outflow in the image below). Emerging markets may show relative strength due to better-placed economies, but downward earnings revisions appear likely and valuations, which trade at a near-premium to developed markets, aren’t particularly attractive.
Similarly, a strong yen and a lackluster domestic growth are likely to hamper Japanese share price performance (reflected in equity outflow in the image below). Emerging markets may show relative strength due to better-placed economies, but downward earnings revisions appear likely and valuations, which trade at a near-premium to developed markets, aren’t particularly attractive.
Whereas FX outlook is a lot more positive in a select few where a) FX reserves are rising; b) the central bank finds the current inflation rate uncomfortably high; c) the central bank appears to have a policy preference for the use of currency appreciation over rate increases as the tool for containment of inflation, leading me to the Brazilian Real and the Chinese renminbi most notably.
US Equities & FX- No strong opinion on market index of late as the bounce in equities has not been all due to short-covering (the main cause for the last 3% rallies) but remain positive on US exporters with majority of revenue outside the US vs. short domestic, highly-leveraged companies with minimal foreign exposure; long large caps/small caps (short); risk arbitrage trades such as MSFT-YHOO, NMX-CME and BCE.
Given the US scenario I referenced, I Ben Bernanke will not only reduce rates but keep them low for a while. Lower risk free rates are needed to cushion the fallout of rising joblessness and tight credit on aggregate demand and investor risk appetites.
Increasing unemployment and broadening out from just housing related losses to nearly every sector of the economy confirms that a vicious cycle of slowing consumer spending, rising business caution, and reduced hiring/production is entrenched, while tight credit, if left unchecked, will continue to be a meaningful drag on demand for credit-sensitive goods (e.g. housing, consumer and business durables). All of which makes me think investors will reach for yield in the long-end of the curve.
EUR Equities & FX- No opinion on market index but am closely monitoring the DAX. Even though ZEW economic expectations index rose to -32.0 points from -39.5 points in Feb, the trend remains to the downside.
The ISM in the US have been on a downward trend. With the US economy slowing and resilience of the world on the US consumer and dollar (even though we've seen diversification into Euros) will lead to a slowdown world wide, especially the industrial aspect which booms during early stages of economic recovery and growth.
Currently, the DAX has a 53% market-cap weight in cyclical industries, higher than any other index in Europe except the OMX. According to the IFO institute notes that fewer companies reported their willingness to hire new staff, compared to previous months. The image below depicts a positive relationship between the IFO and the DAX.
The rising oil prices have been boon for energy companies, and indexes such as the TSX and other related indices, but it's no good for Germany. Why? The DAX offers little protection against the high oil price.
The FTSE 100, MIB have 18%-20% of their market cap in oil stocks, vs. the DAX with no oil companies. Lastly, keep an eye out on the EUR 2s-10s spread because of the positive correlation (0.68) between The German DAX and Euro 2-10s spread. A steep curve would mean a weaker EUR and DAX.
Contributor Yaser Anwar does not hold a financial position in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure policy.