This time last year central banks in the rich world were poised to tighten monetary policy. The US Federal Reserve was expected to continue raising interest rates and the European Central Bank (ECB) president Mario Draghi had announced the end of its programme of quantitative easing.
Faced with a gathering global slowdown central banks have U-turned, switching from tightening to easing monetary policy. Last week the Fed cut rates for the third time in three months. The ECB has recently cut rates further into negative territory and restarted asset purchases. Interest rates are at historic lows in the UK, with the base rate at just 0.75% and markets anticipate the next move by the Bank of England will be down.
Rate cuts and central bank asset purchases aim to reduce the cost, and increase the supply, of credit in order to bolster growth. Central banks have huge influence over credit conditions – but not complete control.
The propensity of banks to lend and corporates to borrow is also influenced by the economic outlook. The prospect of weaker growth is likely to make banks more reluctant to lend, and the private sector more wary of borrowing. Taking on debt is less attractive when growth is weak, uncertainty is high and asset prices are under pressure.
The Bank of England’s regular survey of banks shows that UK lenders are increasingly concerned about the outlook for growth and expect corporate defaults to rise. As a result banks have become more risk averse and are planning to cut back lending to corporates.
A Confederation of British Industry survey of manufacturers reports that in the last six months the cost of credit has had a more adverse effect on manufacturing investment than during the financial crisis.
Demand for credit is slowing. Big UK corporates are more focussed on reducing levels of debt than at any time in the last nine years, according to the latest Deloitte CFO Survey. Just as banks are paring back risk appetite so are corporates.
This makes sense. GDP growth and profits have done well in most Western countries in recent years. But with corporate earnings not far off a cyclical peak and activity slowing the outlook for profits looks less rosy. Corporates bankruptcies in the US and UK are starting to nudge up.
This isn’t only a problem for banks. Corporate bond markets are also at risk.
The cheap-money policies of recent years have lowered the return on safe assets and encouraged investors to move into riskier areas, including corporate debt, in search of higher returns. Non-financial corporates have taken advantage of the new source of funding to switch from equity to cheaper debt finance. In the US, the euro area and China non-financial businesses are running higher levels of debt today than they were ten years ago. (The UK is the exception. Its corporate sector has deleveraged and is now less indebted than those in the euro area and, indeed, China.)
A particular area of concern is the leveraged loan market which typically extends credit to less creditworthy, more indebted companies, usually without the kind of investor protection traditionally sought for such loans.
The leveraged loan market has doubled in size over the last ten years, overshadowing high-yield bonds as a source of financing for riskier businesses. With global growth slowing, and growth in the developed world widely acknowledged to have peaked, investors are beginning to pull back from the market. Many worry that the next recession could bring about a string of corporate defaults that hit these lenders hard.
Analysts at Bank of America Merrill Lynch recently wrote of the US leveraged loan market, “we are seeing numerous new signs of tightening credit conditions…ranging from wide market bifurcation, to a prevalence of downgrades, rising distress, lower availability of capital for the lowest rated names”.
In recent years even less creditworthy businesses have enjoyed easy credit conditions. Credit has been cheap and easy to find. As growth slows banks and the corporate bond market will become more discriminating in their lending decisions.
In the lead up to the general election on December 12, we will provide a brief update each week of the latest opinion polls and betting odds.