The Biggest Downside Risk to Markets

Investing across the cycle requires a firm grasp of the fundamentals, and perhaps nothing is more fundamental than the flow of money and credit.

Indeed, the current economic shock facing the world can be boiled down to a simple one-liner: we are currently in the middle of a liquidity crisis, and the biggest downside risk is that it transitions from a liquidity crisis to a solvency crisis.

As the charts and analysis below show, disruptions in the flow of money and credit can trigger and signal a self-reinforcing downdraft to markets.

That said, I remain constructive on the medium-term outlook for risk assets... but that view rests on a few key underlying assumptions - and requires close monitoring of a number of key indicators.

The following charts and commentary addresses the dynamics at play, what to watch for, and the resultant implications for the risk/return outlook across corporate credit and equities.

1. Lending Standards vs Policy Rates: This is quite a powerful chart - in a way it shows the disconnect between monetary policy easing versus banks tightening up lending standards. In other words, benchmark interest rates may be lower, but it's harder to actually get a loan. In fairness, it is completely understandable that banks would take this stance given the impairment of credit quality, servicing ability, and balance sheets as a direct result of the economic shutdown shock of the pandemic. But it highlights or leads into a couple of other themes and trends worth noting...

global lending standards vs global monetary policy rate chart

What to watch for: In my view, the pandemic is essentially a liquidity crisis in that the vital interlinked system and chain of cash flows has been disrupted for a large part of the economy. The biggest risk is that a more prolonged shutdown turns the liquidity crisis into a solvency crisis (i.e. the shortfalls go from income statement to balance sheet).

2. Credit Managers Index: Studying bank lending surveys often yields actionable insights for longer term investing, but one drawback is the frequency (e.g. the ECB and Fed only conduct quarterly surveys). But we can supplement those with the US Credit Managers Index -- think of it as the PMI for credit. The CMI tracks a set of "favorable" and "unfavorable" factors, and the chart below shows the index for unfavorable factors. Interestingly enough, prior to the pandemic, it turns out that credit managers were seeing the lowest levels of credit stress in years, of course that has clearly crashed now, and there is widespread stress. But this highlights my parting thought above: for now, we are dealing with a liquidity crisis, and whether that turns into a solvency crisis will depend on a combination of: a. Policy Response (fiscal and monetary); b. The Duration of the Economic Shutdown; and c. Firms' ability to Adapt and Evolve (where possible).

US credit managers index chart

What to watch for: Within the surveys I am keeping an eye on a few particular indicators which have proven useful as leading indicators to deeper financial stress in the past. As of the April data, there is obviously deterioration, but not outright capitulation as yet.

3. Lending Standards vs Credit Spreads: For a number of good reasons, credit spreads and lending standards tend to be fairly highly correlated (mostly coincident, but sometimes one leads the other). The main reason is credit spreads can basically be thought of as a real time assessment of the current level of credit quality (of course the market can/does get it wrong from time to time aka presents opportunities to investors). But probably the main takeaway for this chart is how my global credit spread composite indicator is basically confirming the tightening up of credit.

global lending standards vs credit spreads graph