A banking crisis is here – the credit crisis may be next

Damien Klassen | Nucleus Wealth

There is a banking crisis playing out at the moment. On its own, it is unlikely to create major issues, but the credit crunch following the banking crisis will create the major issues.

This time is different

Dangerous words, I know. But this time has already been different. 

Banking crises usually evolve from a wave of defaults as economies slow and corporates go bankrupt. Then investors get worried about bank solvency and start pulling their money from banks. The next step is a credit crunch which makes the situation worse. Banks swimming in capital a few months earlier find themselves abandoned by investors and deposits hard to come by.

In response, banks scale back on their own lending. At the same time, they lift credit standards, only loaning to the better quality corporates. This is known as a credit crunch.

A credit crunch has the effect of making things worse. Corporations find credit hard to come by and expensive, leading to more defaults. And this is usually when we get a banking crisis. After the credit crunch, not before. 

Three paths forward

A credit crunch is not inevitable. Let's group the possibilities into: bull, bear and base cases. 

Bull case

This is the most optimistic. It relies on a 'whatever it takes' type of speech from the US central bank. There are lots of different forms this could take. Basically, it needs to keep credit flowing to the corporates. The problem is if central banks do this, they will effectively be stomping on the brake and accelerator at the same time. 

Central banks are trying to slow credit down. They are raising interest rates to slow credit growth, slow economic activity and therefore bring inflation back under control.

If they go all out quickly and in a big way, they are torpedoing the inflation goal. The bull case is not impossible. But it seems unlikely.

Bear case 

In this scenario, the banking crisis is allowed to get out of control, such as if Credit Suisse had been allowed to fall over. Or, the next major bank that runs into trouble is allowed to fall. It is the consequence of markets chasing from one questionable bank to the next to the next. Allowed to run unchecked, a full-blown, 2008-style financial crisis would occur.

But it is highly unlikely. Generals are usually good at fighting the last war. For central banks, preventing a re-run of the 2008 Financial Crisis is very high on the list of priorities.

Base case 

Central banks and regulators do enough to prevent a financial crisis. They continue to bail out and help banks where possible, but they fall short of a broad 'whatever it takes' approach. 

What does that mean? 

Bank funding costs increase. Deposits flee the smaller banks. Both have already started. 

As a consequence, banks scale back their lending. Interest rates charged are higher. Corporates bear the brunt, the US falls into recession and default rates spike. Inflation is no longer a concern. Central banks can now roll out the big guns.

Net effect: a mini-banking crisis, followed by a credit crunch, possibly followed by a traditional banking crisis. Bad for stocks, good for government bonds, not pretty for corporate bonds. 

What to watch for

The key question from here is which of the three cases is most likely, and how we are going to know which one is happening.

First, we look at surveys of credit availability. Bank officer surveys already suggest that banks were restricting credit before the latest round of bank bailouts. Some purchasing manager surveys show the same thing, but from the point of view of the corporate. 

Talking to companies directly about the issue is probably only of limited value. Companies do not want to advertise problems with funding. 

The more reliable data comes later. Credit growth data will be important. Probably not as important as early indications of bankruptcy statistics. 

Funding costs are important. Credit default swaps on banks and corporate bond spreads are two of a host of indicators. 

Where to hide

Which investments will be safe in this environment? Government bonds will be the key beneficiary of the base or bear case. Corporate bonds give a higher yield but capital loss is the danger.  

Cash will be an attractive option, but if you are over the deposit guarantee limits, choose a larger bank. In Australia, it is highly likely governments will step in and bail out depositors for a large bank.  

From a country perspective, you might need to be more nimble as most regions have their own issues:

• US regional banks have structural reasons to be the epicentre (more loans, more concentrated deposits, more exposure to commercial property, low reserves). 
• However, the European Central Bank has a reputation for being late when it is time to start rescuing. So Europe is not without its risks as well.
• Australian stocks are typically a leveraged play on world growth. If world growth tanks, then the same will likely be true for Australian stocks. And Australia has a much larger banking sector relative to most other markets.

From a sector perspective, you want defensive stocks and high-quality stocks, but which stocks are truly defensive? Commercial real estate is looking a little dicey, so REITs, often considered defensive, are more at risk than other defensive sectors. Energy utilities and infrastructure can have structural issues as they transition away from (suddenly cheaper) fossil fuels, so pick carefully. 

High-quality stocks are those with high margins, low debt and good returns on capital invested. Over the last year, because of inflation, every company has been able to increase prices. The question is which companies can hold on to those price increases as demand tanks, and which will have to return the price rises. Oligopoly sectors, or those with low levels of competition, will be more likely to hold onto the price rises. Sectors with lots of players or competition are significantly more at risk.

Value is not going to save investors during this downturn. It is not the type of recession where value outperforms. This type of recession is where valuation gets hit quite hard because earnings in these value stocks will be more at risk.

Picking up a great company at a decent price 

Just as importantly, you want to have a shopping list of high-quality companies that you always wanted to buy but were too expensive. There is a good chance you will be able to pick them up at a discount. 

First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.

Damien Klassen is the Chief Investment Officer at Nucleus Wealth. This article is general information and does not consider the circumstances of any investor. Analysis as at 23 March 2023. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.