Global Financial Crisis 2.0? Part 6

Chapter 6: The looming credit crisis. What effect will over-leverage have on the real economy?

Well, for one thing, credit will get tighter. We’re already seeing it:

46.5% of polled banking institutions are reporting a decrease in loan VOLUME, while 54.4% are reporting a decrease in loan DEMAND.

In terms of pricing, nearly 70% of institutions are raising the cost of capital. 

According to the Dallas Federal Reserve’s Index, total loan volume is down -23.1 points, just from the last reporting period

Which puts it firmly in “contracting” territory, and as low as it's been since early Q2 2020.

By loan type, consumer loans have understandably lost the most appeal for lenders, followed by residential RE and then commercial RE.

The market has already radically adjusted its expectations of the Fed Funds rate path

The assumption is that the Fed will curtail its hawkishness in an effort to protect all those negative-equity bank balance sheets. Surprise, surprise… more government jiggering and lever-pulling. 

The idea being: if the Fed stops its hikes and brings rates down, all those devalued bonds we talked about will see an INCREASE in value and the banks can slowly climb out of negative equity territory.   

Currently, there’s a ~20% probability that the Fed will actually CUT rates at its next meeting. There’s also a ~25% chance the Fed will neither hike nor cut, instead keeping the current target rate of 475-500 bps.

So much for taming inflation at all costs!

What other effects are we seeing? Well, insurance costs are up… big time

Why the increase in insurance costs? Partly inflation. It costs insurers more to insure assets as they go up in price, and it costs more to keep their staff.

But it also has to do with insurance companies’ investment portfolios, which are over 50% bonds. Will the fun never end?

Like banks, insurers are sitting on a lot of unrealized losses

We know that fixed income investments like bonds have been devalued, which has forced insurers to raise the premiums they charge in order to maintain a positive balance sheet.

In terms of corporate profits, I see NO outcome other than greater earnings compression, and lower Earnings-Per-Share compared to expectations

I touched on this at our last quarterly ACCESS™ Insiders meeting: earnings compression refers to the decline in the earnings-per-share (EPS) for a company, or for an entire index like the Russell 2000 or S&P 500.

There are a number of reasons why earnings-per-share can decline. The 3 most fundamental are:

An increase in the number of shares available

A decrease in companies’ net income (profits)

A combination of both

Whatever the cause, it’s a sign of deteriorating financial performance.

And we’re already seeing it. It began in Q4 2022, when year-over-year earnings growth for the S&P 500 turned negative, to the tune of -4.6%. That’s despite revenue growth of 5.3% YOY. Ooops.

This was the first time in 2 years that the index has reported a YOY decline in earnings, since Q3 2020 (-5.7%).

And it’s only expected to get worse. The projected earnings decline in Q1 2023 is currently -6.5%.

And as this becomes reality for the bigger corporations on the S&P, it will likely catalyze the next leg lower in listed markets.

Bottom line: market participants should be aware of these two risks:

First, contagion/ripple effects spreading into areas of markets where leverage sits (i.e. large event shock risk similar to what we just observed with SVB and company).

Second, the slowdown in the real economy causing revised earnings expectations and lower equity values.

If either/both of these occur, there WILL BE some excellent opportunities ahead. We’ll talk more about that in my next article.