Markets – Slowdown but no credit stress
Over the past week, volatility in global markets massively picked up again, following stress in US regional banks and the UBS takeover of Credit Suisse.
In March, bank equities lost 15%, HY spreads widened 100bp, and 2y Treasuries are 100bp tighter. Markets are rapidly pricing two instances – recession and banking stress.
A slowdown is probably in the cards. Historical analysis suggests bank stocks volatility similar to the one experienced in March leads to lending tightening worth a few tenths of GDP growth, unless offset by policy. A mild contraction (at least) in US and Europe is thus considerably more likely than perceived a few weeks ago. The implication is a gradual slowdown in core inflation, which justifies a softer stance of central banks, and some earnings slowdown. Rates lower and equities lower are thus justified.
Credit, however, is widening back to stressed levels. European and US high yield markets now offer spreads in excess of 500bp, which imply unusually high default rates in both areas. Credit markets are thus pricing stress as a result of recent banks volatility. While the situation remains fluid, we believe those fears may be unwarranted. The banking sector, especially in Europe, is stronger than ever with high capital ratios, healthy asset quality and very diligent supervision. In US, the volatility is limited to regional banks, which means a tightening in credit standards but no systemic risk. Overall, some cracks following an incredibly fast tightening in monetary conditions are emerging, but we think the conclusion markets are drawing on credit stress are arguably too rushed.
Overall, we believe the main implication of the ongoing event is higher chances of a slowdown, and softer outlook for inflation. This means higher downside risks for equities, and lower upside risks for rates. We see low chances of credit stress so generalized increases in credit spreads across sectors remain an opportunity to add risk.
Central banks – Financial stability trumps inflation
For central banks, the narrative shifted towards the trade-off between maintaining financial stability versus inflation.
The ECB attempted last week at a policy reaction that harmonize both. Last week, the central bank hiked rates as expected by 0.5% to 3%, and overall lowered headline inflation projections while raising core inflation forecasts by 0.4% to 4.6% in 2023. Priority remains to fight inflation, with headline inflation still projected above target for the full horizon until 2025. Guidance on further hikes was removed from the statement, returning emphasis on data dependence and the meeting-by-meeting approach. Most importantly, Lagarde included supportive statements on the soundness of the European banking sector, stressing the robust liquidity support in place at the ECB should stress emerge in the financial system.
The Fed will have a hard task this week, as fears on the financial system intensify. While the central bank is likely to continue its hiking cycle with a 25bp move, we think the guidance for future meeting will be considerably more open, and less dovish, comparted to the past few meetings. Data dependence will take the center stage, and the Fed will need to acknowledge good progress on inflation vs a re-prioritization of the ongoing risks.
Overall, the ongoing volatility in financial markets will inevitably lead to a tightening in credit standards. While a quantification is very hard at this stage, it is enough for a slowdown, and potentially a long break, in central banks hiking pace, especially given the mature phase of the hiking cycle.
Algebris Investments’ Global Credit Team
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