The second quarter earnings season is under way. If investors were looking to the early indications of company results for some relief from the relentless rants about an impending recession, they were disappointed. Out of the gate on Thursday, we heard from two US financial giants – JP Morgan and Morgan Stanley – with both showing declines in earnings and recognizing the headwinds facing the economy. Both banks have been forced to take action to bolster capital in the wake of last month’s Federal Reserve stress tests, indicating a balance sheet shortfall in the event the economy were to be hit with a major calamity.

 

In the case of JP Morgan, it has had to increase loan loss provisions by more than $400 million and has suspended share buybacks. The increase in provisions is an immediate hit to earnings, just like it was back at the start of the pandemic. Readers will remember that Canadian banks went through the same exercise of having to boost loan loss reserves at the start of the pandemic, only to pull them back once the economy got back on its feet. Boosting them again is going to add to the mounting concern that economic times are going to get tough. Even worse, JP Morgan is also being forced to take steps to reduce risk assets (those backed by the bank’s capital) and is planning to get out of mortgage securities.

 

Annual Federal Reserve stress tests were put in place after the Financial Crisis of 2008 as a way to ensure the viability of the financial system in the wake of massive failures like Lehman Brothers and Bear Stearns. They are a good idea, but banks have criticized them for their lack of transparency and lack of connection with the real economy. With monetary policy getting aggressively tighter, financial conditions in the US (I will deal with Canada in a moment) are becoming more punitive. Most economists expect a recession to emerge over the next 12 months – a situation where you would want banks to provide more credit to businesses and households, not less.

 

Keep in mind that the Federal Reserve is also in the process of reversing its unprecedented program of bond buying, which included mortgage-backed securities – what the market refers to as quantitative tightening, or QT. What this means is that bonds which are maturing are not being reinvested in the market. If banks also start to unload securities, this could put even more upward pressure on prevailing yields and tighten conditions further. The trickle-down effect on the real economy is being compounded by higher borrowing costs, higher prices for non-discretionary goods and services and a negative portfolio effect on confidence.

 

 

 

While JP Morgan and Morgan Stanley have come out publicly against the Fed’s stress test rationale, they also painted an upbeat picture of where the US economy is. Indeed, metrics that we would look to as measurements of distress are not ringing alarm bells. The above chart shows the spread between triple-B corporate bonds in the US versus the 10yr US government bond. That spread recently crossed above 2%, which is double where we got last year in our money for nothing world; however, it is still well below the peak at the beginning of the pandemic and nothing close to where investment grade spreads got in the Financial Crisis.

 

 

 

Usually, we would expect to see real signs of distress in high yield spreads, and we have seen a little more cause for concern here than on the investment grade side. The BarCap 10yr spread between high yield corporate debt and the benchmark government yield has tripled from the 2021 low to a recent high of around 6% this month. Again, this is still well below the pandemic high, and also the peaks in 2011 and 2016. We might have been saying something similar in 1998, at the time of Asian crisis, when high-yield spreads had just started to vault up through 6%. Despite a brief reprieve before Y2K, spreads would widen out to a high of above 10% after the recessionary phase of the early years of 2000-2002.

 

I bring up this comparison for a good reason, because there is potentially another central bank mistake waiting in the wings. In 2021, the mistake was not starting a program of modest rate increases and quantitative tightening soon enough. Inflation was north of 5% by the summer and economic growth was solid. Instead, the Fed and Bank of Canada waited until the markets told them they were behind the curve and that their “transitory” comments on inflation were out of touch. In my opinion, their mistake was not in using the term “transitory”, but in framing that word with such a vague timeframe context that media pundits and the public thought they meant we would be out of the woods in a few months. They should have said high inflation was transitory over a period of 1-3 years. Water under the bridge. They painted themselves into a corner and then went into reaction mode, culminating in the aggressive rate hikes of this summer.

 

 

 

As Ally and I discussed on Wednesday, the Bank of Canada seems hell bent to project independence, not only from the federal government, but from the Federal Reserve as well, evidenced by its surprise 100 basis point rate hike. Chances are the Fed will simply just raise rates another 75 basis points at the next meeting – something that is being telegraphed by various Fed officials – but it would be foolhardy to rule out a copycat move of what Ottawa delivered. Still, at this point in time, the Bank of Canada overnight rate target sits at 2.5% - equal to the high-water mark for the Fed prior to the pandemic and the highest we have seen in this country since 2008.

 

But, back to 1998. With Canadian and US central banks playing catch up and forcing rates higher, despite existing signs that inflation is abating in several segments of the economy, there is a currency problem as well. If the Bank of Canada thought that its surprise hike this week would cause the Loonie to soar higher (which is another weapon in the fight against inflation), it just didn’t pan out that way. The canuck buck extended declines and broke below 76 US cents on Thursday. We haven’t been at these levels since November 2020.

 

As for the 3.6% decline in the value of the Loonie versus the US dollar this year, this is actually the best performance of the G10 group of currencies. Multiply that loss by five and you arrive at the drop in the Japanese Yen. Every major Asian currency is also down much more than our Loonie and the same holds true for emerging markets, whether in Asia or LatAm and Europe. What we have to keep in mind is that consumer products in these countries are predominantly quoted in US dollars. When the US dollar goes up against their currencies, the imported price is inflated, and this fuels their domestic inflation.

 

 

Even if emerging economies were not experiencing significant upward pressure on inflation, this would still be problematic; however, the opposite is true. Consumer price inflation across emerging economies is now back to 5%, not far off the pre-pandemic high. The problem is that inflation control mechanisms are not as robust in these economies as in North America. The chart above shows the spike in inflation in 1998, but even that 10% rate is miniscule relative to decades before. Though, it was enough to spark a crisis in Asian financial markets, which spilled over into the rest of the world.

 

I personally believe that the whole inflation issue in North America is transitory and will be dealt with, albeit with significant pain for some segments of the population. And, if that is all we have to contend with, then equity and fixed income assets have an opportunity to recover. If, on the other hand, we create another chasm offshore then we would have to re-evaluate the recovery scenario. Unfortunately, if the Fed continues to drive interest rates appreciably higher, the dollar strength will continue as rate differentials widen and investors seek haven in the greenback in the face of market volatility. That will exacerbate the inflation pressures in emerging countries and make it harder to repay US dollar denominated debt.

 

For those who have been saying that globalization has died in the wake of the pandemic need only look at what is happening to realize that the international economic and financial linkages are still alive and well. The feedback loop back into our home markets also remains strong, and policy makers need to address this, or simple earnings misses will be the least of our worries this summer.

 

On behalf of the Pyle Group, have a wonderful weekend.   

 

Andrew

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.