Credit and equity markets can turn quickly if market fears dissipate
The global financial sector was particularly hard hit last week, on concerns over decelerating Chinese growth and potential exposure to a stressed commodity sector. Suspicions that Deutsche Bank would be unable to meet the coupon on some of its hybrid capital provided the proximate cause, as its credit default swap-spreads ballooned out beyond their GFC levels.
While certain other European banks also suffered on funding concerns, the major falls were confined to these specific names – the rest of the financial sector also sold off, but to nowhere near the same extent. This rationality may reflect the understanding that a GFC-style global banking freeze is far less likely given the greater liquidity and stronger capital buffers than existed in 2008.
That said, credit and equity markets are currently reflecting legitimate concerns. Credit market spreads have reached current levels five times in the last 30 years. Three resulted in a genuine credit cycle downturn – an accelerating increase in bad loans – while two did not. Commodity-related debt remains an issue in scale, if not in timing. Companies have been terming out debt in recent times, so that we are not due a large-scale refinancing across the sector in the near-term. However the amount of debt is so large that the market may ultimately find it hard to absorb, particularly if commodities remain under stress at that point.
In 2011 a slump in sentiment from a possible Eurozone disintegration and the sovereign debt downgrade of the US saw a similar spike in credit spreads, which did not translate to a cycle downturn. In that instance, market fears were allayed by QE and central bank intervention. While a perversely weak Nikkei and strong yen following the Bank of Japan’s announcement of negative interest rates has raised questions about the current efficacy of central bank policy tools, it is worth remembering how quickly markets can turn as fears dissipate. In that vein, the market will be watching closely for any sign of supply discipline within OPEC. A statement over the weekend from PBOC Governor, Zhou Xiaochuan, that there was no need for further currency devaluation may also have a calming effect.
It is difficult to predict if today’s signals translate into a credit cycle downturn or not. Either way, current spreads may have an eventual impact on the Australian economy in the form of tighter credit standards and less lending. Should the credit market remain under stress long enough, there is a risk that concerns become self-fulfilling. However, it is important to note that there is a big difference between having to pay more for funding and not being able to access funding at all. The latter was at the heart of the GFC. Today, greater capitalisation, better liquidity and more precise matching of funding means that Australian banks are having to pay a bit more for funding, but the funding is still there. What it does highlight is that growth is likely to remain subdued and interest rates low for an extended period of time.
In terms of the reporting season thus far, decent results from domestically focused companies such as Bluescope Steel, JB Hi-Fi and Boral have revealed a degree of resilience in the Australian economy, reflecting the benefits of a weak currency and government infrastructure spend. Financials’ results have been patchier, as slowing top-line growth renders it harder to maintain margins.