2nd August 2016
Mark Holman, Partner, CEO & Portfolio Manager Twentyfour Asset Management looks at an influential banking survey.
For fixed income investors focussed on obtaining yield from the market and therefore investing to a reasonable degree in credit risk, understanding where we are in the economic cycle is one of the most important inputs into risk taking. The most tricky point for investors often occurs at the end of the cycle which can be consistent with a much higher default rate, higher credit spreads and a recession. This does not happen very often, but we can all remember how spectacular events were in 2008.
There are many factors that contribute to the conditions seen at the end of cycles, but one we look at very closely here is the change to bank lending standards and credit availability. We have previously commented on both the Credit Conditions Survey in UK and also the ECB’s Bank Lending Survey, but it is in the US where the cycle is most advanced and yesterday the US published its equivalent release, known as the Senior Loan Officer Opinion Survey.
This is a very broad survey covering 71 domestic banks and 23 US branches of foreign banks (by contrast the UK covers the 6 leading banks plus Nationwide BS) and like the UK, it is released quarterly and feeds into the Federal Reserve Board.
What we are looking for in these surveys is signs of tightening of financial conditions; are banks lending at lower or higher rates, either due to policy induced change or through risk reasons, thereby charging different spreads to their cost of funding? Are they lending lower or higher volumes, are they tightening or loosening their credit standards and to whom are they lending?
In aggregate; are the banks fuelling the economy or are they putting the brakes on?
History has consistently told us that when banks are in aggregate tightening, it nearly always signals the end of the cycle and the beginning of a recession. This tightening can come from the central bank directly or from the banks themselves through lower risk appetite. Usually the former is the main driver as policy is directed to take the heat out of the economy. Having had such low rates for so long and then seeing the first hike from the Fed in December, we are likely to see the first signs of the end of the cycle through this bank survey. Conditions had already begun to modestly tighten pre that first hike last year and both the Q1 survey and yesterday’s survey, have again, confirmed this trend.
However, before we get too excited that the end of the cycle is upon us, we need to look at the detail. It is a lengthy report so I will just summarise. The tightening of conditions is very moderate in most cases, with lenders showing unchanged conditions over the prior period. Lending to the all important consumer sector remains underpinned by strong demand and ongoing willingness to lend. Perhaps the only small caution would be unsecured lending to the lower quality borrowers (sub-prime). Within consumer lending the only hint of any nervousness comes from auto loans, where there is a marginal reduction in risk appetite, but again nothing to be concerned about at this stage.
The sector that has seen the greatest amount of tightening is the commercial real estate sector, but into a backdrop of continued strong demand for loans.
The commercial and industrial sector saw an overall modest tightening, primarily to larger corporates, and it was influenced by the metals mining and energy sector fallout from Q4 2015 and Q1 2016. The SME sector remains very well supported at this stage.
Putting this modest tightening into context, I had a quick look at the Senior Loan Officer Reports from 2007 and 2008, which as we know was just prior to a significant recession, just to remind myself what the language looked like back then. The two sets of reports use very different language and the levels of tightening were very large indeed, being broad-based for those periods. From this we can take comfort that the banks are continuing to support the recovery and that although we are late cycle, as yet, there are no hints from the banks that the end of the cycle is around the corner for US credit. This modest tightening could continue for some time.