Crunchety Crunch

Murray Gunn on May 5, 2023

The credit crunch continues.

The European Central Bank published its Euro Area Bank Lending Survey (BLS) for the first quarter this week and it provides further evidence that the supply of, and demand for, credit is drying up. This is the headline paragraph from the report:

“In the April 2023 BLS, euro area banks indicated that their credit standards for loans or credit lines to enterprises tightened further substantially in the first quarter of 2023. From a historical perspective, the pace of net tightening in credit standards remained at the highest level since the euro area sovereign debt crisis in 2011. The tightening was stronger than banks had expected in the previous quarter and points to a persistent weakening of loan dynamics. Risks related to the economic outlook and firm-specific situation remained the main driver of the tightening of credit standards, while banks’ lower risk tolerance also contributed. The tightening impact of banks’ cost of funds and balance sheet situation on credit standards for loans to firms remained contained and broadly unchanged compared with the previous quarter. In the second quarter of 2023, euro area banks expect a further, though more moderate tightening for loans to firms.”

Lending standards also continued to tighten for housing and consumer loans, whilst demand for loans continues to drop with higher interest rates the main factor cited.

So, the ECB should be happy, right? This is what it wants to slow the economy and curb the rate of change in consumer prices. This, plus the stable consumer price inflation figures for April, will probably mean the ECB only hikes its policy interest rate by 25-basis points tomorrow. A 50-basis point hike would now be a shocker.

The thing is, though, the ECB cannot control what risk committees in commercial banks are thinking. The histogram in the chart below shows the net percentages for responses to questions related to contributing factors in relation to decisions on lending standards. This is defined as the difference between the percentage of banks reporting that the given factor contributed to a tightening and the percentage reporting that it contributed to an easing.

We can see that it is overwhelmingly risk perceptions and tolerance which drive decisions on lending standards, and with corporate credit spreads yet to really widen, the worst of the downgrade and default cycle looks to be still ahead of us. Money market futures are already pricing in an interest rate cut from the ECB by the middle of next year. If, as we suspect, stock markets continue to decline, that pricing of cuts will very likely be brought forward in time.

Croak! Defaults Starting to Accelerate.

Murray Gunn on March 31, 2023

Debt deflation is happening.

You know that terrible apologue about the frog in a pan of boiling water? Putting aside what kind of brain thought that up in the first place, the point of the story is that the frog doesn’t know it is being boiled alive until the point of its demise. This came to mind when I was thinking about what is going on in financial markets.

The relentless rise in bond yields and interest rates since 2020, accelerating last year, has been akin to the boiling water. One frog in this metaphor was Silicon Valley Bank and, of course, there are others. All of a sudden, it seems, companies are realizing that the water has been boiling for some time.

The December 2022 issue of the Elliott Wave Financial Forecast highlighted the fact that so-called zombie companies, those that can’t produce enough cash to service their debt, have proliferated since 2020. Zombies now account for 24% of the Russell 3000 stock market index (almost a quarter!). The previous peak was 16% during the dot.com bust at the start of the century.

Now, evidence is emerging that debt deflation is starting to ramp up. The chart below shows that corporate defaults have zoomed higher in the first two months of this year and are now at the fastest year-to-date clip since 2009. Credit rating agencies have, shall we say, a ‘checkered’ past but the 12-month average of the number of credit downgrades is sloping up, meaning that the trend is toward deteriorating credit quality. And corporates face a wall of refinancing to be negotiated over the next couple of years.

2023 is fast becoming the year in which people realize that the cost of money and debt has changed, and is not returning to the easy days of the past. Hey, do you smell something cooking?

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