The collapse of Credit Suisse, an icon of European banking, has revived fears of the Global Financial Crisis (GFC). In this week’s Market Perspectives, we take a step back and consider where the global economy and financial markets might be in say 3-6 months’ time.
There are three big differences between the current crisis and the GFC. First of all, inflation today is well above target in developed economies and has persistently exceeded central banks’ forecasts. That limits their freedom of manoeuvre. By contrast, core inflation was low in the US and Europe ahead of the collapse of Lehman Brothers in 2008 and had been on a declining trend for decades. Second, the financial system then had huge leveraged exposure to the property sector. On one measure, British banks’ exposure to property was more than 100% of their deposits. Finally, of course, we’ve had the GFC and financial regulation has greatly strengthened.
Recent events have tightened credit conditions in a world where they were already getting more restrictive. The chart shows that banks in the US and Europe were tightening lending standards to companies well before the latest crisis. In the case of US lending to small firms, the pace of change was approaching that seen in the GFC. This data relates to January – we’ll have to wait until next month for an update and will surely see a further sharp tightening.
So, will the Federal Reserve (Fed) reverse course, choose not to raise rates this week and then start cutting aggressively? The Fed will be reluctant to cut rates while the labour market is so very tight and inflation so high. Cutting rates too early was a mistake they believe they made in past inflation periods. They then had to reverse course and the result was a deeper recession than if they had held their nerve. So, their bias may well be to provide assistance to the financial system but resist cutting interest rates too early.
However, there are signs that underlying inflation pressures are easing in the US. The influential Atlanta wage tracker was published a few days ago and showed a major turn. In particular, the wage growth of people who switched jobs in the last year fell sharply relative to those who had stayed put. A major source of upward pressure on wages has eased. This follows the modest growth in earnings shown in the recent employment report. In addition, the US producer price index has slowed significantly with signs of a further squeeze on corporate margins. This index is much broader than it used to be, much broader than it is in other countries and provides a good measure of pipeline inflation across the US economy.
The missing piece, in the jigsaw of falling US inflation, is the labour market which remains extraordinarily tight. There is a link from the tighter credit conditions shown in the chart and employment in the US. The lag is long and variable but the Federal Reserve will be alert to this.
So, I think we are close to the peak in US interst rates and significant declines are likely by year end.
The situation in Europe is quite different. Credit Suisse’s woes do not appear to be matched elsewhere in European banks. Yes, wiping out Credit Suisse’s bonds was a shock and will make it more expensive for banks to raise further capital. Lending standards will tighten further. But falling energy prices are a major source of improving confidence for both consumers and corporates in Europe. Finances of both sectors are strong. The European Central Bank was right to press ahead with a 50 bps rate hike last week. Core inflation in Europe is rising and wage pressures are strong. It is quite possible that European interest rates will end the year above those in the US.
As for the Bank of England, they might be relieved that it isn’t British banks that are making the headlines. Falling energy prices means that UK inflation is set to tumble and fears of recession have receded. The recent Budget will have added to these trends. Wage pressures have already eased here and the headwinds from higher mortgage rates are strong. So they may go ahead with another rate hike, but only 25 bps. Either way, we are close to a peak in UK interest rates in my view.
So, what does all this mean for markets? First, government bonds look attractive. Despite all the turmoil, US TIPS, the US equivalent of UK index-linked gilts, yield 1.2% currently. That’s a real yield above US inflation and looks pretty good for the best credit in the world during a crisis. Second, we might see a weaker dollar due to divergent interest rate trends. Not the usual pattern in a crisis. Third, equities look a tad expensive. They may present a great buying opportunity at some point but perhaps not quite yet.
Until next week, goodbye.
