Banks Face Trouble As Credit Cycle Turns

By Simon White, Bloomberg Markets Live Commentator and Analyst

Weak stock markets and worsening growth data – today’s miss in the flash PMI is case in point – did not deter Jamie Dimon from making positive comments on credit and the US economy at the WEF summit in Davos yesterday. Banks jumped on his remarks, but they face an increasingly challenging environment as the credit cycle turns and growth slows.

Bank outperformance is more closely linked to longer-term yields than the yield curve, and as a sector it is the most sensitive to changes in yields.

But bonds are already oversold, and as economic data starts to disappoint (today’s disappointing flash PMI is case in point), yields face greater resistance. Moreover, the only seasonally positive months for yields — January to April — are now behind us, with yields on average falling in the latter two-thirds of the year.

Everything in macro operates with lags of varying lengths, and the rise in yields has fed into credit through a fall in loan demand and tighter lending conditions.

The credit cycle itself operates in a well-defined sequence: first lending conditions tighten, the loan demand falls, followed by a fall in loan supply. Loan delinquencies then rise as more loans go bad, followed by a rise in charge-off rates as losses are realized. Finally, bankruptcies rise as loan losses lead to insolvencies.

The tightening of lending conditions today is captured by the steady widening of credit spreads, signalling the credit cycle is turning.The rise in charge-off rates typically follows wider credit spreads by six months.

Banks can pre-empt losses by increasing their loan-loss provisions. They did this at the beginning of the pandemic, but they turned out to be way more pessimistic than necessary, given the depth and breadth of fiscal and monetary support given to the economy. However, the loan-loss provisions of US banks are now negative, meaning there is currently zero absorbency for approaching loan losses. Banks were over-prepared in 2020, and they are under-prepared now.

It’s possible of course the growth scare is a storm in a teacup, and that credit spreads will soon tighten again. But that is not the way to bet, with a swathe of leading indicators from manufacturing new orders to heavy truck sales all pointing in the direction of an acceleration in growth’s decline in the coming months.

Inflation won’t help banks either. Elevated and persistent inflation typically leads to the real value of bank assets heading to zero faster than the real value of liabilities. Financials were in the bottom third of performers of sectors and asset classes through the four inflationary regimes experienced since the 1970s.

There are times when the macro stars align, pointing to a great trade set-up, but this is not one of them, despite what a bank CEO may say.