The rise in global economic pessimism can trigger a series of adverse events in financial markets and overall economic activity.
As the renowned banker JP Morgan once expressed, liquidity is like a taxi in New York on a rainy night—it disappears just when you need it most.
In financial circles, it’s a well-established saying that credit markets always lead stock markets.
Credit markets are notably reliant on the availability of liquidity at a desired cost, fundamentally rooted in “confidence.”
An initial crisis can significantly amplify if confidence evaporates from financial and credit markets.
This process always begins with increasing pessimism in the economy, and as sentiment becomes more negative, credit to the economy dries up.
We are currently witnessing the early signs of a tightening in global credit.
As more restrictive monetary policy takes effect, economic growth starts to crumble in the West.
Meanwhile, in the East, we’ve been seeing disappointing growth and inflation figures from China recently.
Given these developments, it’s crucial to delve deeper into the global economic landscape to fully understand what’s happening and the challenges facing the world economy.
Tightening Financial Conditions
The issue of “tightening” financial conditions has been a recurring theme in Jerome Powell’s recent policies.
Although markets have been perplexed, measures of financial conditions, such as the GS Financial Conditions Index or the Chicago Financial Conditions Index, have remained relatively loose.
Clarifying his position, Powell made it clear he was referring to tighter lending standards.
To assess these standards, the Federal Reserve conducts the Senior Loan Officer Opinion Survey (SLOOS) quarterly, with results available before the FOMC meeting.
This survey helps Fed members analyze bank lending standards and credit demand from households and businesses.
The Latest SLOOS
The latest SLOOS is particularly important as it was conducted after the closure of the SVB on March 27.
Responses were obtained from 65 domestic banks and 19 agencies in the United States.
Interestingly, the commercial real estate (CRE) sector witnessed considerable tightening as banks were cautious about lending to this sector due to growing concerns.
CRE prices continue to plummet, especially in areas like New York and San Francisco.
This represents a double whammy for CRE developers, already facing high vacancy rates.
Tighter lending standards mean the sector will be short of liquidity just when it needs it most, as maturities approach later this year.
It’s estimated that up to $500 billion in CRE loans will mature over the next 15-18 months.
Additionally, loans to small, medium, and large businesses have also decreased.
However, small businesses are a crucial element of the U.S. economy, representing 99% of all businesses, 65% of employment growth, 50% of all jobs, and 44% of all economic activity. Thus, they play a vital role in the country’s economic resilience.
Economic Challenges
These trends point to a challenging scenario where tighter lending standards and a lack of liquidity could negatively impact various sectors of the economy.
It is essential to closely monitor these developments and consider the broader implications for the global economy.
Overall, the survey revealed that 46% of the institutions consulted responded affirmatively about tightening lending standards.
It’s important to interpret these results correctly, as some market participants misinterpret them, arguing that it’s a small change from the previous quarter.
However, it’s crucial to appreciate the information adequately: the SLOOS should be read as “46% of banks further tightened lending standards from already tight levels in the first quarter.”
Historical Perspective
Looking at history as a reference, we can anticipate a collapse in credit demand over the next 3-4 quarters.
A contraction in credit in a highly financialized economy will likely result in a decline in economic growth.
Interestingly, even during the 1970s, when the Federal Reserve adopted extremely tight monetary policies to curb rampant inflation, recessions were marked by tighter lending standards.
Banks operate on the premise of “short-term borrowing, long-term lending.”
An inverted yield curve, where short-term rates rise significantly more than long-term rates, discourages lending operations.
Consequently, tighter lending standards begin as soon as the yield curve inverts and intensify during a recession (although the yield curve tends to steepen sharply during this period).
Since banks operate with significant leverage, unprofitable transactions negatively impact their profitability.
Therefore, an inverted yield curve is usually accompanied by a decline in Net Interest Margins (NIMs).
The Role of Smaller Banks
Given that smaller banks have recently been responsible for most lending, their retreat could be a blessing in disguise for shadow banks, likely to step in to fill the void.
However, it’s important to note that shadow banks typically charge much higher rates than traditional banks.
As a result, we are heading toward a significant increase in the cost of capital, which will have a catastrophic impact, especially on small and medium-sized enterprises.
European Economic Data
Regarding economic data in Europe, the awaited release of the Consumer Price Index (CPI) was a positive surprise.
For months, I’ve mentioned that the headline number would fall to around 4-4.5% in June, but the real challenge lies in reducing it from 4% to 2%.
The headline CPI hit 4.9%, with food and energy costs continuing their downward trajectory due to the base effect.
It’s important to note that core goods saw a rebound, driven by the lagged effect of rising used car prices.
Another relevant indicator is the “Supercore,” also known as Core Services Ex-Housing, which the Federal Reserve monitors to assess underlying inflation rigidity.
This indicator also showed moderation, providing some comfort to Jerome Powell, known as JayPo.
U.S. Inflation Outlook
The story of inflation in the second half is closely tied to wage evolution and the rise in the unemployment rate (UR).
Any increase above 5% (more than 260 basis points from the current 3.4%) will result in a drop in average hourly earnings (AHE) to pre-pandemic levels.
However, if the unemployment rate does not exceed 4.5%, inflation may stabilize around 3%.
Emerging Signs of Fragility
Nevertheless, a caveat must be made regarding exogenous shocks and credit events. We are beginning to see the first signs of fragility in the labor market.
Weekly jobless claims data are the key indicator for unemployment and are pointing to a near-recession scenario.
Europe’s Economic Woes
Looking at Europe, the situation is concerning as inflation expectations have started to rise, and there is a risk of de-anchoring associated with wage increases.
Moreover, factory orders and industrial production are declining in parts of the Euro Area, such as Germany and Sweden.
Fears of stagflation are growing daily as underlying inflation remains considerably higher than the European Central Bank (ECB) deposit rate.
This week’s surprise came from the Bank of England (BoE), which raised its growth projections and indicated that a “more flexible fiscal policy” is a broad inflationary pressure factor in the economy.
Policy Adjustments Needed
Monetary policy in Europe, including the UK, is still accommodative, as underlying inflation is significantly above interest rates.
Therefore, sustained restrictive policy is necessary to combat the inflationary fire.
The Chinese Dilemma
The much-anticipated Chinese reopening saga is not unfolding as markets predicted.
What was believed to be the year’s biggest story now appears to be an undeniable challenge for China.
Although broad money supply (M2) and credit impulse initially saw a jump after the reopening, they now seem to have stalled.
Recent data indicate that M2 contracted month-on-month, and the credit impulse appears to have peaked.
Credit impulse in China is widely used as a proxy for industrial commodities and crude oil, and a decline in this impulse does not bode well for the commodities market.
New yuan loans saw a drastic drop from 3,890 billion to 718.8 billion last month.
On the other hand, Chinese households are prioritizing debt reduction and increasing spending on services rather than goods.
Chinese Import Decline
Consequently, Chinese imports fell further, registering a 7.9% decline, indicating weak domestic demand for foreign products.
The final blow came from the inflation data, which were disastrous.
Even after a quarter of full reopening, China is now on the brink of deflation, with the Consumer Price Index (CPI) falling to 0.1%, while the Producer Price Index (PPI) remains deeply negative.
Deflationary Concerns
Deflationary conditions are disastrous for manufacturers and would result in stagnant corporate profitability as they squeeze margins and erode pricing power.
As a result, cyclical profits are likely to remain under pressure in China.
Additionally, the last thing the People’s Bank of China (PBoC) wants is deflation at a time when the painful deleveraging process in the real estate sector is underway. The situation is concerning.
Conclusion
The foundation of global growth is shaken.
As credit availability diminishes in the United States and credit demand drops due to the rising cost of capital, growth will moderate and likely enter a recession in the coming quarters.
In Europe, the decline in growth seems more imminent, with a collapse in industrial production while inflation remains stable due to wages continuing to rise above trend.
The greatest concern for global growth lies in the East, where the animal spirit has failed to revive in China, and the sluggish real estate sector continues to dampen consumer sentiment.
In summary, as the second half progresses, a considerable slowdown in global growth is expected, while the return of U.S. inflation below 3% will depend on labor market developments.
This is a time of economic uncertainty and significant challenges.
It is essential for investors and decision-makers to stay alert to developments and adjust their strategies accordingly.
As always, the future is uncertain, but having a clear understanding of economic indicators and trends is crucial for navigating the challenging times ahead.
Be prepared and stay vigilant for opportunities that arise because, in times of turmoil
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