Credit Research Outlook Q2 2023 Not There Yet
An important factor to consider in evaluating credit conditions is the debt-servicing costs, which have risen across developed market economies. We expect credit conditions to weaken more materially in countries that have seen leverage rise (even if modestly) and debt service ratios increase.
Our update at the end of Q1 focused on the brewing crisis in the US regional banking sector. While the elements that caused the US regional bank failures in March were not prevalent in the banks on our credit approval list, we expressed concern that stress on US regional banks could materially weaken the US and global economy if it led to materially less bank credit availability. There was concern that weakened credit conditions would imminently push the US into recession. So what happened thereafter?
In the US, bank deposits and loan assets have been relatively stable, even within the regional bank sector, for over two months since the extreme volatility of March (source: “US Bank Brief,” Jason Goldberg, Barclays Equity Research, 26 June 2023). While credit conditions continue to tighten modestly, the trajectory has not changed since the US regional bank failures. Indeed, the latest Senior Loan Officer Opinion Survey in the US does not reveal any ramifications from the bank failures, nor do similar surveys in other jurisdictions. This type of survey is particularly important for economies where financial intermediation is more bank-based than in the US, such as Europe, where declines in bank lending activity are more consequential for the economic outlook.
Meanwhile, the global economy continues to demonstrate modest resilience. Labor markets remain quite strong, supporting global services sectors. Even housing markets have proved resilient, especially in the US, despite significantly higher interest rates. While core inflation rates in the US and the eurozone have begun to ease modestly, they remain above the US Federal Reserve’s (Fed) and the European Central Bank’s comfort zones. Inflation rates in the UK, Australia, and Scandinavian countries have proven more sticky. None of these factors indicates pervasive economic weakness, let alone recession.
Credit conditions in the banking and debt capital markets have remained broadly healthy through most of this monetary policy tightening cycle. The cost of credit is higher, but there has not been a rationing of credit to qualified borrowers. In a “credit tightening,” qualified borrowers can obtain funding even if they have to pay a higher premium for it. A higher cost of credit should restrain growth, but not cripple it. This is what we are seeing at present, rather than the imminent threat of a full-blown “credit crunch,” wherein high-quality borrowers would not be able to obtain credit at a rational cost.
An important factor in the consideration of credit conditions is the debt-servicing costs, which have risen across developed market economies, but sit broadly at levels lower than during the expansion in the 2000s (“Debt service costs rising for most interest sensitive,” J.P. Morgan Global Economics Research, 26 June 2023). The current health of balance sheets (in particular, consumer balance sheets) reflects the sharp deleveraging that took place in the aftermath of the Global Financial Crisis (GFC), and partly mitigates the impact of rising rates on debt-servicing costs, as has the increase in income levels for households and businesses.
The largest increases in debt-servicing costs over the past year have occurred in Canada, Australia, and Scandinavian countries – all countries with more flexible-rate debt and higher leverage, and thus higher estimated initial sensitivities to rising rates.
We expect credit conditions to weaken more materially in countries that have seen leverage rise (even if modestly) and debt service ratios increase. Notably, there are some important global cash investment counterparties in the countries with higher relative leverage, such as Canada, Australia and Sweden. While those counterparties will continue to be under close scrutiny by our credit research team, we take comfort in the continued strength of the banks on our approval list with regard to profitability, asset quality, liquidity and capitalization. In other words, there is significant scope for these banks to maintain a relatively stable credit profile while the economy weakens.
Finally, we take comfort in the fact that the US regional banking stress has not materially spilled over to non-US banks in our investment universe, such as those in the European, Canadian, Australian, and Asian banking sectors. The lack of stress generally reflects stickier deposit bases, more limited scope for unrecognized mark-to-market losses on securities portfolios, less acute commercial real estate (CRE) concerns, and “smaller banks” being a less material portion of their respective banking sectors. These fundamental factors give us comfort that risks of systemic financial stress from the banking systems in our investment universe are limited.
Still, we believe that most of the negative macroeconomic impact from this aggressive monetary policy tightening cycle is yet to be felt, as the rate hikes work through the economy in a typical lagged manner. The conditions that trigger reductions in credit supply and credit demand are expected to continue for the foreseeable future. The ultimate impact will depend on the persistence of inflation, the response of central banks, the trajectory of credit markets, and the underlying resilience of the economies.
We are hopeful that the strength of banking systems, and the relative health of consumer and corporate balance sheets will mitigate the depth and duration of recessionary conditions in global economies. The onset of recession will always weaken banks as it pertains to profitability and asset quality, but our major investment counterparties continue to demonstrate strong measures of capitalization, liquidity and funding stability.