Can markets cause a recession?

12 February 2016

Market volatility continued as anticipated last week, but took a decisive step towards causing more lasting potential damage to the real economy. This was as banks became the latest focal point of concern which manifested itself not only in steep falls of their share prices (see above), but also in a steep rise in the cost of insurance against possible default of debt issued by banks. The specific cause for concern was not even really increasing credit risk per se but rather that central banks may follow Japan's example and lower interest rates further into negative territory. This, so the thinking goes, may undermine the profitability of banks further and cause them to skip yield payments on so called Coco bonds, they have issued over recent years. These Contingent Convertible bonds pay much higher coupons than ordinary bank debt securities, but can stop interest payments if a bank choses to and furthermore, automatically convert into equity if a bank's standing deteriorates below a certain threshold. Their issuance has helped European banks to bolster their capital ratios without having to issue more equity (which would have diluted down existing shareholders and share prices). The flipside is that this has made many lower risk investors who were searching for higher income contingent and somewhat accidental bank investors. This is fine as long as times are good, but at the slightest inkling that they may be exposed to some risk in return for their generous income receipts they quickly head for the exit. The quickest way to achieve this is through the purchase of credit default insurance in the form of credit default swaps (CDS). Unfortunately this drives up the price of CDS and is therefore seen as a market indicator for a (negative) change in the credit worthiness of the issuing bank. As with anything that is suddenly developing upward price momentum, short term punters sense a trading opportunity and jump on the buying bandwagon, which drives the CDS price up further and gradually develops a self-enforcing dynamic against the bank who finds its credit standing suddenly significantly reduced by these market indicators. This increases its cost of refinancing and thus now really undermines its profitability. This can all happen on the back of rumour rather than factual deterioration of their outstanding loan book. Back in 2012, decisive action by the European Central Bank averted a further deterioration and scared away most of those with only speculative motives for buying CDS. This time, some commentators are expressing doubt whether Central Banks can repeat their 2012 actions, because markets may have become immune against monetary interventions by central banks. This could mean that the pressure on particularly the more exposed European banks stays for longer and prevents them from lending to industry and consumers at the recently improved volumes. This has the potential to reverse the European economic upward trend. On the other hand compared to 2011/2012 and 2008/2009 this time around there is no significant actual economic or debt crisis under way as it is still predominantly a crisis of investor confidence resulting in fear driven risk reduction selling pressures. From this angle central banks remain very potent counter forces with the deepest pockets of all market participants. As ECB head Mario Draghi has made clear on numerous occasions, they will do whatever it takes to ensure the gradual normalisation of the economy and finance stays on track. I am hoping actual ECB intervention will not be necessary but just an unveiled mention of potential central bank action to counter unwarranted market pressures has significant potential to reverse prevailing dynamics. This is what turned sentiment in the summer of 2012 and it is within the ECB's power in 2016 just as much. The German finance minister's reassurances this past week that he has no doubt that Deutsche Bank is solid and will withstand this episode could be seen as a first sign of the extent the monetary and political authorities may be prepared to go to prevent a true deterioration of the financial and economic outlook in Europe. Once the 2012 crisis was resolved it was followed by a prolonged period of very solid investment returns as confidence returned and the recovery continued. There is little to suggest to me that this time will be much different. However, what is much harder to predict is how much longer and how much deeper the current environment of mostly fear driven selling pressure is going to carry on. After last week's testimony by US Fed chair Janet Yellen before Congress the next stop will be the ECB meeting on 10 March. Until then at the very least, I am afraid, the debate will continue whether market wash outs themselves can cause recessions, what the real cause for the market action may be and whether we live in a New Normal where the past no longer provides any guidance for the future. More volatility ahead therefore and more danger that investors will lose their nerve, crystalize their losses for cash and then miss a rapid recovery.