[Economics] When the real economy generates an 'illusion' and the financial one is the one that reveals the harsh reality

[#Wittels-]

During the years of expansive monetary policies (low interest rates and large stimuli), the financial economy was accused of living in a parallel reality to that of the real economy. Stock markets and bonds were at record levels, interest rates were historically low and bank stress was non-existent. On the contrary, during that period, the real economy was barely growing, salaries were stagnant during and the labor market did not finish fueling. Today, the situation seems to have reversed, something that at first might even seem positive. If the real economy works, what does the financial one matter, many citizens will wonder. Today, the economy is apparently strong, wages are rising (although consumers are losing purchasing power), and labor markets are showing strong data. However, the financial pipes are on the brink of collapse. Can the real economy survive without the help of the financial?

Recent economic data has painted a relatively positive picture of business activity in most developed countries. For example, service sector PMI data for April points to expansion at the fastest pace in a year, raising hopes/expectations that a sharp and longer economic slowdown can be avoided.

Looking only at the real economy, the odds of a recession or even a single quarter of contraction appear to have dropped substantially since last winter, thanks to the jobs, GDP and PMI data. However, the financial pipes present an advanced state of deterioration. When the pipes break and the water does not reach its destination... we have a problem.

 

credit dries up
On the one hand, there is the uncertainty and contraction of credit as a result of the bankruptcy of several banks in the US. Although the prices seem to have stabilized in recent days, when a bank falls, the contagion effect is a real risk whose mitigation is extremely difficult, since depositors and investors are encouraged to move their money to safer places due to many messages of calm launched by the Fed. Although the crisis seems to be solved after each resolution (SVB, Signature Bank, First Republic...), the truth is that fear simply jumps from bank to bank until a great firewall is established.

The regional bank is reeling
"The recent bankruptcy of First Republic bank has shown that the ripples of the banking crisis have moved through the financial sector and, at the time of writing, it appears that California-based PacWest could be the next victim." they say from the British think tank Center for Economics and Business Research (Cebr).

The words "credit tightening," "credit crunch" and "credit crunch" are increasingly appearing in conversations among institutional investors, Tan Kai Xan, an analyst at Gavekal Research, said in a note to clients.

The macro concern is that US companies will respond by cutting their capital spending and cutting back on hiring. Therefore, "as credit tightens and becomes more difficult to obtain, bankruptcies in the US can be expected to increase, which will cause the labor market to weaken and growth to evaporate," adds the Gavekal economist. Investigation.

deposit leak
"While JP Morgan's acquisition of First Republic Bank has eased fears in the banking system, deposits are expected to continue to flow out of US banks, especially after the Fed stood firm on rate hikes last week. That move increased the incentive for depositors to move their savings into higher-yielding money market funds," warns Kai Xan. Assets most closely tied to the Fed's effective interest rates see their yields rise almost immediately, while banks are unable to keep up.

This situation forces affected banks to borrow wholesale at more expensive rates and, on the other hand, to sell assets to reduce their balance sheets in an attempt to maintain balance. "The net effect will be lower credit creation and a tougher contraction. Things are unlikely to improve until the Fed starts cutting rates, but that's unlikely to happen until the US hits recession, which will be another headache for the banks," says Tan Kai Xan.

Europe and the UK trail behind the US
It is true that, so far, the UK and European banks seem to be less affected or exposed to what is happening, with the exception of Credit Suisse. "However, under the surface there are signs that banks on both sides of the Atlantic are reacting to the new economic environment, becoming more cautious and reducing new lending, to the detriment of the real economy," Cebr experts warned.

Central bank surveys
Also, much of the damage has already been done. The latest data on financial surveys conducted by the US Fed and the ECB in the Eurozone reveal that the financial pipes have stopped working. The central banks have 'cut off' liquidity and the impact on the economy will be felt sooner or later.

The good GDP and PMI data have generated a kind of illusion, a prediction that seems excessively optimistic and premature. Victory cannot yet be claimed, let alone seeing what is happening with the banking sector in the US and in some monetary aggregates, warn the think tank Cebr.

In the Eurozone, the latest survey on bank loans from the European Central Bank (ECB) reveals that in the first quarter of this year banks suffered credit at the highest rate since the 2011 sovereign debt crisis.

Similarly, in the US, credit conditions are holding up and reaching levels that could be described as exceptionally "tight". According to the American Bankers Association's Credit Conditions Index, expectations about credit market conditions are at their lowest since the start of the pandemic, suggesting that US businesses will find it more difficult to obtain loans from banks in the coming months.

The rises in interest rates since the end of 2021 are the main factor in the current situation of the banks. Although SVB's risk management appears to have been exceptionally poor, "it is very likely that other banks also have some longer-term government bonds that have lost value since central banks around the world decide to raise rates," they argue. the economists of the british think tank. These are counted as assets on the balance sheet of bank securities, so if their value falls, liabilities (i.e. deposits) will eventually need to be reduced as well.

Furthermore, the refusal or inability, especially by US banks, to pass on the higher interest rates to their savings accounts means that deposits have flown out of the banking system at a staggering rate. Estimates put money outflows at JP Morgan, Wells Fargo and Bank of America over the past year topping half a trillion dollars.

Meanwhile, the British withdrew a record £4.8bn from UK banks in March alone. Although there are still big differences, financial instability in the US will also cause small waves of distrust in Europe. In the case of Spain, for example, the large banks have also lost around 30 billion euros in deposits since December, according to their recently published quarterly accounts.

"In summary, the data suggests that companies (and to a lesser extent potential homebuyers) will find it increasingly difficult to obtain a loan in the coming months. This will have a dampening effect on investment and economic growth, and It is one of the main reasons for our most pessimistic outlook for the world economy," say the Cebr economists.

Central banks are in a difficult situation as core inflation is also expected to remain higher for longer than expected, making it more difficult or even impossible for interest rate cuts to begin. stimulate the credit market. All in all, "the current cycle of interest rate increases could have come to an end in May, but it is unlikely that the work of the Federal Reserve, the ECB and the BoE will be easier in the coming months," they say from the Cebr .

 

Link: https://www.eleconomista.es/mercados-cotizaciones/noticias/12266775/05/23/cuando-la-economia-real-genera-una-ilusion-y-la-financiera-es-la-que-revela-la-cruda-realidad.html