Pendragon

History, Credit Markets and Financial Crisis

 
Michael E. Porter

In Charles Kindleberger’s book “Manias, Panics, and Crashes: A History of Financial Crises” a comprehensive history of financial crises is presented. This is the playbook for how an economy evolves and it suggests that a financial crisis is more common than many believe. Starting at the South Sea Company bubble, Kindleberger presents a thesis that throughout history financial crises have had many common characteristics. They are a common result of the business cycle, and happen more frequently than investors care to imagine. Kindleberger concludes, that a financial crisis does not come out of thin air, it evolves and manifests itself first in the credit market. To be clear, there will be another financial crisis, but, with the calmness shown by the credit markets globally over the past, it is not happening yet. The concern about higher interest rates and the global trade war we experienced over the past months was manifested mostly in the equity market.

 

History suggests that there are a few sign posts to determine whether there is financial stress in the economy. The St. Louis Federal Reserve Financial Stress Index has a reading of close to -1, suggesting that financial conditions are good. For prospective, the Index was close to +1 in the year 2000 and it had a reading of +5 in 2008. The interest rate spread between high quality bonds (AAA-rated) and low quality bonds (CCC-rated) is close to 3.5% as at November 6, 2018. In the run up to 2000 and 2008 this spread was above 6%, peaking at 15% in the 2001-2002 period and at over 25% in 2008-2009. Doing the above exercise, but replacing the low quality CCC bonds with low quality emerging market bonds, gives us the same result. There is no excessive stress in the emerging market credit markets. With regards to the action by the Federal Reserve (“Fed”), the yield curve has yet to invert, signaling that conditions are still good for credit creation. In addition, the relationship between the yield on the 2-year Treasury Bill and the effective fund rate is positive, suggesting that the credit market does not think the Fed is raising interest rates too fast. As of yet, a policy mistake has not been made. Simply put, the credit market is not signalling and did not give any early warning that the global economy is heading for a financial crisis. Sorry, no 2008 event yet.

 

Regarding the fears of inflation running away and the global trade war: inflation expectations are well anchored. The 5-year breakeven inflation rate is below 2%. The breakeven inflation rate is a market based measure of expected inflation. It is the difference between the yield on a nominal bond and an inflation linked bond of the same maturity. In fact, this measure peaked in May of 2018 at 2.14%. At the time of writing this note, the number was 1.91%, which is a decline of inflationary expectations of 23 basis points, which means, inflationary expectations are well anchored.

 

It’s been widely accepted in the West that China has been lacking in implementing the market based reforms it agreed to do when it became a member of the World Trade Organization. However, in June of this year the China National Development and Reform Commission (“NDRC”) announced that as of July 28th the country’s negative list of industries, where foreign ownership is prohibited or restricted, would be reduced from 63 to 48. BMW and Ford recently have announced that they will increase their ownership stake in their China enterprises. Can Mr. Trump and Mr. Xi come to an agreement on intellectual property rights? Only time will tell. But China has already been moving away from low value added manufacturing and making its economy more market based. Maybe not fast enough for some, but indications are that a trade deal is a real possibility.

 

To summarize, there is no financial stress in the credit markets, inflation expectations are well anchored, the bond market is comfortable with the Federal Reserve’s interest rate policy for now, and there are signs that China is slowly opening up its economy. We view this as an opportunity.

 

Dr. James E. Thorne
Chief Capital Market Strategist & Senior Portfolio Manager

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