In its October 2010 edition, The McKinsey Quarterly reminds us of the cyclicality of the world economy and sheds some more light on the relationships between economic growth and triggers of financial crises. The interesting part, not completely new but introducing an idea that contradicts collective wisdom is that executives who want to anticipate recessions need to look at the more complex (and for non-financial sector actors quite difficult to follow) credit markets as recession pre-warning systems.
Subscribers to the theory that markets process all information efficiently would argue that equity investors would be in a very good shape to recognize early indications of a looming downturn. However, the performance of equity markets shows that they haven’t been a good predictor of past recessions. During the major recessions since the early 1970ies, most of the decline in the S&P500 Index occurred after the economy has already slowed. This, the article reckons, is based on the importance of statistic data for stock price movements.
While equity markets may not predict economic trends well, their depth provides investors with liquidity, so they generally work well during difficult times and buyers and sellers can sell and buy at reasonable prices.
In contrast to equity markets, credit markets, don’t always function smoothly during difficult times. This, the article states, is why they are a better source of information about where the economy is heading. There are also some cases like the recent property debacle in the US, the 1990 crisis in Japan or the Latin American crisis of 1980 (spurred by excessive government borrowing) that show that the credit markets are frequently the origin of recessions. However, the transparency of credit markets is far lower compared to equity markets and the following other characteristics make them more prone to instability:
- Debt is sold (by brokers) rather than bought (by investors) and the markets tend to be illiquid.
- Banks typically invest in long-term loans financed by short-term loans at a lower interest rate which works well at normal yield curves, but if the yield curve gets inverted, actors try to sell their short term deposits often at distressed prices.
- The system suffers from chronic group think where participants copy successful strategies from their peers and life of contrarians is difficult due to their lack of resources
- Expectations of government bailout create tremendous moral hazards which were reflected in the willingness of the banks to lend money to the Greek government at comparably low spreads. This security protracted Greek’s financial misery but made it difficult to follow for private investors.
If you want to foreshadow a looming downturn (it takes several years for crises to develop), the McKinsey Quarterly article proposes to consider the following three indicators:
- Deterioration of lending standards: What amount of due diligence do banks go through before they grant loans and how strict are the criteria imposed to the debtors?
- Unusually high leverage and mismatches between assets and liabilities due to change of yield curves, currency movements, etc.
- Frequent transactions that do not create value like repackaging mortgages via collateralized debt obligations that led to the fall of Lehman brothers in 2008 or debt moved to off-balance-sheet positions that caused the fall of Enron in 2001.
The takeaway apart from the need to be aware of the general cyclicality of the world economy is that it is better to look at credit markets to anticipate down turns. For executives in non banking industries, that do not have a good insight into credit markets it is however important to check the sentiment of lenders with regards to appraising new loans, major changes in asset-liability-equations and an accumulation of exotic transactions.